Producing Liquidity

An asset is liquid if its owner can trade it without incurring significant transaction cost. Thus, currency is liquid because it can be converted into goods or services, or other assets, due to its wide acceptance, at very low cost in time or value. By contrast, real estate is illiquid in most contexts because the transaction costs to convert it into other goods and services, or other assets, are relatively high. In modern economies, simply put, liquidity is the ability to meet financial obligations. On the supply side, banks provide financial instruments (deposit products) that allow agents to meet their obligations along with the additional services such as safekeeping and record keeping. Furthermore, there is a possibility of earning an interest income. On the demand side, Barnett (1978, 1980) showed by applying capital theory to financial assets that the liquidity of an asset to its holder—the monetary services it yields or its “moneyness†—is indicated by the margin between the holder’s cost of capital—a “benchmark†rate of return on an asset yielding no monetary services—and the total return on the asset (the rate of property income and expected holding gains, if any). This paper focuses on how economic statistics such as Gross Domestic Product (GDP) account for liquidity services in recording economic performance. We first examine the liquidity services provided by banks (depository institutions), and then broaden our analysis to the liquidity services produced by other enterprises. The paper also considers an alternative view of liquidity services—as provided by the owners of financial assets for their own use—rather than the prevailing approach in the national accounts—as provided by financial institutions to other units in the economy.