Economies in every country need manufactured, natural, human, social and financial capital input to grow. However, while economists may agree on the overall factors -- often called production factors -- that cause or retard economic growth, there are differing opinions and theories on the weight each brings to the economic growth equation. When it comes to financial capital input -- especially as it relates to stock market transactions -- how much, or even whether stock market liquidity affects economic growth depends on the theory you adapt and how a government view trading shares on the open market.
Stock market liquidity refers to the overall affect trading shares on the open market has on market prices. In general, the less effect trading activity has on market price, the more liquid the market. You can measure stock market liquidity by analyzing three factors. The first is the difference between the best quoted ask price -- or the highest price you are willing to pay for a share of stock -- and the best quote bid price -- or the lowest price a seller is willing to take for a share of stock. The closer the bid-ask spread, the more liquid the stock market. The second refers to how the level of market activity affects stock prices. The third refers to resiliency, or the amount of time it takes for the market to return to a state of equilibrium after periods of heavy activity.
Stock market liquidity is a good predictor of the potential for economic growth says Brown University economist Ross Levine. The main reason for this, according to Levine, is that a liquid stock market increases market confidence, reduces inherent risk levels by making it easier for investors to distinguish good from bad investments and more fully develops the market. The result is a move toward better allocation of capital as investments in declining industries and “bad” projects decreases and investments in growing industries and “good” projects increases, with a net effect of enhanced prospects for long-term economic growth.
Two additional theories offer the possibility that stock market liquidity has a flat to negative effect on economic growth. The first says that that a more fully developed market decreases savings rates and weakens corporate control, thus preventing economic growth. The second discounts the effect of the stock market almost completely, calling it, according to Levine, a “sideshow” where investors simply come to play.
Increasing the positive effect that stock market liquidity can have on economic growth -- and decreasing the arguments against its effect -- depends in large part on government policies. Liberalizing the legal, regulatory, accounting, tax and supervisory systems policies that play a role in influencing stock market liquidity works to encourage stock market investments while policies that place restrictions on stock market trading have an opposite effect.
- The Encyclopedia of Earth: Economic Growth
- “Stock market Liquidity and Economic Growth: Theory and Evidence”; Ross Levine
- RiskGlossary.com: Liquidity
- Programme for Workers’ Activities: Stock Markets: A Spur to Economic Growth
- Journal of Financial Economics: Financial Markets and the Allocation of Capital
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