liquidity trap

Examples of liquidity trap in the following topics:

• Deflation

  • In the IS/LM model (Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly with a fall in the aggregate level of demand.
  • This can produce a liquidity trap.

• Liquidity

  • In accounting, liquidity (or accounting liquidity) is a measure of the ability of a debtor to pay his debts when they fall due.
  • The main categories of assets are usually listed first, and typically in order of liquidity.
  • Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves.
  • The liquidity ratio (acid test) is a ratio used to determine the liquidity of a business entity.
  • The formula is the following: LR = liquid assets / short-term liabilities.

• Liquidity and Bond Prices

  • Liquidity causes bond prices and interest rates to differ.
  • For instance, U.S. government securities are widely traded and are the most liquid.
  • Then the secondary markets expand for government bonds boosting the liquidity for these securities.
  • Consequently, the investors are attracted to the government bonds because they are more liquid.
  • Taking the difference between the two interest rates, we measure the degree of liquidity.

• Liquidation Preference

  • The main purpose of a liquidation where the company is insolvent is to satisfy claims in the manner and order prescribed by law.
  • The liquidator must determine the company's title to property in its possession.
  • Shareholders (Liquidating distribution) - Most preferred stocks are preferred as to assets in the event of liquidation of the corporation.
  • Stock preferred as to assets is preferred stock that receives special treatment in liquidation.
  • Summarize how the liquidation preference determines which claims will be paid if a company becomes insolvent

• Defining Spread

  • The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity.
  • Liquidity demanders place market orders and liquidity suppliers place limit orders.
  • For a round trip (a purchase and sale together), the liquidity demander pays the spread and the liquidity supplier earns the spread.
  • In some markets such as NASDAQ, dealers supply liquidity.
  • However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders.

• Reasons for Maintaining Cash on Hand

  • In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses.
  • Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained.
  • The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity.
  • Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand.
  • Most banks are subject to legally mandated requirements intended to help banks avoid a liquidity crisis.

• Preferred Stock Rules and Rights

  • Preferred stock can include rights such as preemption, convertibility, callability, and dividend and liquidation preference.
  • Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation.
  • The following features are usually associated with preferred stock: Preference in dividends preference in assets, in the event of liquidation, convertibility to common stock, callability, and at the option of the corporation.
  • Preferred stock may or may not have a fixed liquidation value (or par value) associated with it.
  • Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par (or liquidation) value, unless otherwise negotiated.

• Current Ratio

  • Liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash.
  • The liquidity ratio is the result of dividing the total cash by short-term borrowings.
  • Acid Test - a ratio used to determine the liquidity of a business entity.
  • The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands.
  • High liquidity means a company has the ability to meet its short-term obligations.

• Importance of Working Capital

  • Working capital (WC) is a measurement of a company's operating liquidity.
  • WC is a signal of a company's operating liquidity .
  • Large companies pay attention to WC for the same reason as small ones do: WC is a measure of liquidity, and thus is a measure of their future credit-worthiness.
  • WC is only one measure of a company's operating liquidity.
  • Liquidity is a measurement of a company's ability to quickly turn assets into cash.

• Answers to Chapter 9 Questions

  • Investors prefer to hold liquid securities.
  • Thus, investors increase their demand for the highly liquid bonds and decrease their demand for the low liquid ones.
  • Consequently, bond prices increase for the liquid bonds but decrease for the non-liquid bonds.
  • Moreover, the interest rates are lower for the liquid bonds and higher for the non-liquid bonds.
  • Thus, the securities have the same risk, liquidity, information costs, and taxes.