US Market Liquidity and Its Macroeconomic and Financial Implications: Constructing a Composite Liquidity Index Using Dynamic Factor Models

Abstract

This paper uses dynamic factor model estimation to create a novel index for US xed income nancial market liquidity. This liquidity measure spans the dimensions of liquidity and consider its dynamics. The index o ers insight into the current debate between policymakers and the private sector regarding the state of liquidity in US markets since the recent nancial crisis. The liquidity index depicts a new, lower liquidity level with higher liquidity volatility com- pared to pre-crisis, a result that had not been shown empirically before. The liquidity index is then incorporated into a large-scale factor augmented vector autoregressive model for US real and financial markets. This estimation offers some of the first quantitative insight into the relationship between liquidity and a rich set of US variables.