Liquidity is essential for the functioning of financial markets from "summary" of The Economics of Money, Banking and Financial Markets, eBook, Global Edition by Frederic S. Mishkin
The ability to buy or sell financial assets quickly and without significantly affecting their prices is known as liquidity. Liquidity is crucial for the smooth operation of financial markets. Without sufficient liquidity, markets can become illiquid, making it difficult for investors to buy or sell assets at fair prices. In illiquid markets, investors may be forced to accept lower prices to sell assets quickly or pay higher prices to buy assets promptly. This can lead to price volatility and reduce market efficiency. Liquidity allows investors to trade assets easily, which helps ensure that prices reflect all available information and that markets are more stable. Moreover, liquidity is essential for the proper functioning of financial intermediaries such as banks and mutual funds. These institutions rely on liquidity to meet the demands of depositors or investors who may want to withdraw their funds at any time. Without sufficient liquidity, financial intermediaries may not be able to honor their commitments, leading to financial instability. In times of crisis, such as during the global financial crisis of 2008, liquidity shortages can quickly escalate into financial panics. When investors lose confidence in the ability to buy or sell assets, they may engage in fire sales, exacerbating price declines and market disruptions. Central banks and other policymakers often intervene during crises to provide liquidity to markets and prevent a full-blown financial collapse.- Liquidity plays a vital role in maintaining the functioning of financial markets. It ensures that assets can be bought and sold efficiently, helps stabilize prices, and enables financial intermediaries to meet their obligations. Without liquidity, markets can become volatile, inefficient, and prone to crises.
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