Liquidity is the amount of capital that is available for investment and spending. Most of the capital is credit rather than cash. That's because the large financial institutions that do most investments prefer using borrowed money. Even consumers have traditionally preferred credit cards to debit cards, checks or cash.
High liquidity means there is a lot of capital. That usually happens when interest rates are low, and so capital is easily available. Low interest rates mean credit is cheap, which reduces the risk of borrowing. That's because the return only has to be higher than the interest rate, so more investments look good. In this way, high liquidity spurs economic growth. The Federal Reservemanages liquidity by guiding the interest rate withmonetary policy to set the target for the Fed funds rate.
A liquidity glut develops when there is too much capital looking for too few investments. This can lead to inflation. As cheap money chases fewer and fewer good investments, whether its houses, gold, or high tech companies, then the prices of those assets increase. This leads to "irrational exuberance." Investors only think that the prices will rise, and everyone wants to buy more now so they don't miss any profit.
Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before prices drop further. This is what happened with mortgage-backed securities during the Subprime Mortgage Crisis. This phase of the business cycle, known as contraction, usually leads to a recession.
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