relationship between liquidity, interest rate and asset prices

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Relation between liquidity, interest rate & asset price;

Liquidity and Asset Prices

Overly rapid monetary expansion, or excessive liquidity, has been named as a leading suspect in some episodes of unsustainable movements in asset prices. Liquidity is not a precise concept, however. Liquidity could be measured narrowly as central bank money, or more broadly to reflect the multiplier effects of the financial system; sometimes it is measured instead by the level of policy interest rates. Some commentators have taken a circular approach: If monetary conditions were comparatively easy when asset prices experienced a significant swing, then liquidity must have been "excessive."

A productivity shock or a sharp decrease in energy prices, for example, could lead to general economic expansion and rising asset prices while goods prices are not rising. This situation might allow more liquid monetary conditions than would otherwise be the case. Distinguishing the various forces in play obviously requires tools that are finer than simple observations that both liquidity measures and assets prices are moving together.

Interaction of Asset Prices and Policy

Asset price movements that are discontinuous or extreme can affect the policy process in at least two important ways. First, because they are interest-sensitive, asset prices are primary components of the channels by which monetary policy is transmitted to the real economy. The tax reform of 1990, which among other things made the tax treatment of mortgage interest rates in Sweden considerably less favorable, contributed to a subsequent drop in property prices that ultimately severely stressed banks' balance sheets, an experience that again highlighted the potential impact of such structural factors on asset price movements.
Among other complications is the possibility that financial ...