A liquidity squeeze or credit crunch is used to illustrate conditions when monetary policy is constricting in an economy.
In an attempt to avoid an acceleration in inflation and debt, central banks may tighten monetary policy if they believe the demands for services and goods outpace that of the economy’s output capacity.
Generally, this is performed by increasing interest rates or sometimes through the restriction of reserves of the banking system.
This hinders the bank’s ability to create liquidity through the creation of new money and credit.
Another effect stemming from a tightening of monetary policy would be an appreciation in the cost of credit or at least until availability is confined until the output capacity of the economy aligns in proportion once more.
Examples of Liquidity Squeezes
When China took the blunt force of the economic fallout after the novel coronavirus, China performed a liquidity squeeze by cutting banks’ reserve requirements for the second time in 2020.
Shortly following China, the U.S. Federal Reserve in mid-March 2020 followed suit through Treasury bond purchases equating to $37 billion, which accelerated market liquidity.
On March 13th, 2020, the Bank of Japan pledged to buy short-term loans worth $1.5 trillion while buying 200 billion yen worth of bonds.
Other examples include Norway’s central bank cutting rates in 2020, during which Sweden began offering loans, and earlier in Asia.
The Indonesian central bank also bought 6 trillion rupiahs worth of government bonds at auction shortly after the central bank of Australia injected $8.8 billion Australian dollars into its financial system.