In a market economy, a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods. As the production of goods and services increases, this results in a greater demand for the services of the medium of exchange (the service that money provides). Conversely, as economic activity slows down the demand for the services of money follows suit.
The demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange. People now demand more money to facilitate more expensive goods and services. A fall in the prices of goods and services results in a decline in the demand for the medium of exchange.
According to Mises,
The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power. 1
Increase in the Money Supply and Liquidity
Take the example where an increase in the supply of money for a given state of economic activity has taken place. Since we did not have a change in the demand for the services of the medium of exchange this means that people now have a surplus of money or an increase in monetary liquidity.
Obviously, no individual wants to hold more money than is required. An individual can get rid of surplus cash by exchanging the money for goods and assets. Individuals as a group however cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual.
The mechanism that generates the elimination of the surplus of cash is the increase in the prices of goods and assets. Once individuals start to employ the surplus cash in acquiring goods and assets this pushes their prices higher. As a result, the demand for the services of money increases. All this in turn works towards the elimination of the monetary surplus.
Once money enters a particular market, this means that more money is now paid for a product in that market. Alternatively, we can say that the price of a good in this market has now gone up. (Note that a price is the number of dollars per unit of something).
Observe that what has triggered increases in the prices of goods and assets in various markets is the increase in the monetary surplus or monetary liquidity in response to the increase in the money supply.
Decline in the Money Supply and Liquidity
While increases in the money supply for a given level of economic activity results in a monetary surplus, a fall in the money supply for a given level of economic activity leads to a monetary deficit.
Individuals still demand the same amount of the services from the medium of exchange. To accommodate this they will start selling goods and assets, thus pushing their prices down.
At lower prices, the demand for the services of the medium of exchange declines and this in turn works towards the elimination of the monetary deficit.
Change in Liquidity Due to Changes in Economic Activity and Prices
A change in liquidity, or monetary surplus, can also take place in response to changes in economic activity and changes in prices.
For instance, an increase in liquidity can emerge for a given stock of money and a decline in economic activity. A fall in economic activity results in fewer goods produced. This means that less goods are going to be exchanged—implying a decline in the demand for the services of money—the services of the medium of exchange.
Once a surplus of money emerges, it produces exactly the same outcome with respect to the prices of goods and services and assets as the increase in money supply does i.e. pushes prices higher. An increase in prices in turn works towards the elimination of the surplus of money—the elimination of monetary liquidity.
Conversely, an increase in economic activity while the stock of money stays unchanged produces a monetary deficit. This in turn sets in motion the selling of goods and assets thereby depressing their prices. The fall in prices in turn works towards the elimination of the monetary deficit.
In our framework we define this emerging gap between the interplay of the supply and demand for money in terms of its growth momentum
% Change in Liquidity = % Change in Money Supply minus % Change in Real Economic Activity minus % Change in Price Inflation
Again, changes in liquidity during a time interval are driven by changes in the supply of money versus changes in the demand for money.
Monetary Growth and Liquidity: Are They Positively Correlated?
Some commentators associate the increase in liquidity with the increase in the money supply. This is however, not always the case.
In fact, an increase in the money supply growth rate could be associated with a decline in the growth rate of liquidity. Conversely, it is quite possible that a fall in the money supply growth rate could be associated with a rise in the liquidity growth rate.
For instance, if the money supply fell by 10 percent and was accompanied by a decline in economic activity by 10 percent and a decline in price inflation by 5 percent, this would then result in an increase in liquidity by 5 percent, calculated as follows:
% Change in Liquidity = –10% – (–10%) – (–5%) = +5%
Historically there have been occasions when money supply and liquidity have not moved in tandem. Between October 1929 and July 1932, for example, the yearly growth rate of money supply plunged from 8.3 percent to –14.5 percent while during the same period liquidity increased from 0.2 percent to 26.5 percent.
Notwithstanding the increase in liquidity, the S&P500 fell sharply. The stock price index after closing at 16.7 by March 1931 fell to 4.4 by June 1932—a decline of 73.7 percent (see chart below).
A plunge in the pool of real savings was the likely key cause for the decline in the stock market. Again, this nosedive took place notwithstanding the strong increase in liquidity.
Changes in money supply and liquidity are not the same thing. Liquidity is the outcome of the interplay between the supply of and the demand for money. Contrary to commonly held beliefs, it is possible that changes in money supply and liquidity will move in different directions.