A:

Inflation has the same effect on liquid assets as any other type of asset, except that liquid assets tend to appreciate in value less over time. This means that, on net, liquid assets are more vulnerable to the negative impact of inflation. In terms of the broader economy, higher rates of inflation tend to cause individuals and businesses to hold fewer liquid assets.

Types of Liquid Assets

Cash is the most liquid asset in modern economies. This is because cash can be exchanged for all other assets immediately. The liquidity of noncash assets is based on how easily they can be converted into cash. Highly liquid noncash assets include savings account deposits, marketable securities in high-traded markets, certificates of deposit (CDs) and tax refunds. The benefit of holding liquid assets is increased flexibility and short-term solvency. For a variety of reasons, assets that are highly liquid tend to not receive large guaranteed interest rates.

Inflation and Purchasing Power

Inflation occurs when the supply of money increases relative to the level of productive output in the economy. Prices tend to rise because more dollars are chasing relatively fewer goods. Another way of stating this phenomenon is that the purchasing power of each money unit declines.

Illiquid assets are also affected by inflation, but they have a natural defense if they appreciate in value or receive interest. One of the chief reasons most workers place money into stocks, bonds and mutual funds is to keep their savings safe from the effects of inflation. When inflation is high enough, individuals often convert their liquid assets into interest-paying assets, or they spend the liquid assets on consumer goods.

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