Liquidity and wealth
National income
is an official measure of the flow of new goods and services
produced in a country during a year. A country’s wealth is the value of the
stock of assets created over a period, and which last into the future, and
beyond a single year. Income is converted into wealth when assets are purchased.
For example, a new house built and sold in a given year forms part of that
year’s national income, but it also becomes part of national wealth, as the
house will last for many years.
Types of wealth
Wealth is held in many forms, including:
Personal wealth
Personal wealth includes physical assets such as houses, land, motor cars,
computers and antiques, savings from previous income,
share holdings, and
cash in the bank.
Corporate wealth
Corporate wealth includes physical assets such as buildings, equipment,
machinery, and a wide variety of financial assets. Financial assets
include holdings of
bonds and
shares in other firms, cash
in the bank, foreign currencies, repayments on loans due from debtors, and
the value of unsold stocks.
Businesses tend to differentiate current assets, which exist
for one year or less, and long-term assets, which last several years.
Wealth effects
A wealth effect refers to changes in household
or corporate spending that can occur
as a response to changes in the value of wealth. Wealth effects can be
positive and negative. They are most commonly associated with changes in
house
prices, share and
bond prices.
Annual
household net worth 2002 - 2010
Net Worth
While the average level of household wealth in the UK has risen over
time, it is volatile, and the
house price
crashes of 1990 - 1993, and 2008 - 2009, led to a steep falls in wealth levels.
Household spending is affected by changes in household wealth through a
process called
equity withdrawal, and changes in confidence levels.
Liquid and illiquid assets
Wealth can also be looked at in terms of liquidity, which is the
ease with which an asset can be converted into cash. Cash is considered
to be perfectly liquid, whereas fixed assets like machinery and
premises are extremely illiquid.
The macro-economic system needs considerable liquidity to
facilitate the circular flow of income. The recent
credit crunch, like
previous economic disturbances, was triggered by sudden
changes in the availability of liquidity. As banks,
firms and households look to reduce their risks they often reallocate their
wealth from illiquid forms to liquid forms. However, as they increase
and protect their own liquidity, less liquidity is made available to others.
In a
sense, people hoard liquidity which perversely reduces liquidity in
the whole macro-economic system.
For example, banks may call in loans or make fewer loans,
and in
turn, firms may hold fewer stocks and prefer to hold cash. To
compound matters, anxious households may save more of their income,
and hold more cash, which reduces spending on consumer goods, and
further reduces liquidity.
See also: The
financial crisis and quantitative
easing