The Liquidity Squeeze

The definition of liquidity shortage’

Liquidity happens when concern about the short-term availability of money causes reluctance of financial institutions and gives money from its reserves. It reserves causes the interbank market rate to rise, making it more expensive for banks to borrow from each other. Ultimately, this results in credit standards to tighten, making it more difficult and expensive for consumers to get loans.

Breaking down the ‘liquidity squeeze’

Liquidity squeezes occur when banks become more reluctant to borrow money from its reserves, because the money can tighten. If banks lend out their reserves, but cannot substitute for the reserves on the cheap by borrowing from other institutions, they cannot meet their reserve requirements. The lack of available credit for consumers may cause a pullback in consumer spending, which, if prolonged, could hurt economic growth. In order to limit the impact of liquidity squeezes, Central banks will often increase liquidity by injecting money into the economy by lowering interest rates.

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