Part 7 · Connecting the economy to stocks · Lesson 38
Liquidity: when money is released, assets rise
When money is plentiful, asset prices float up; when money drains out, they sink. Liquidity is the hidden force that moves the multiple knob.
QToday's question
In 2020 the economy froze because of COVID, so why did stock prices rise so much, even into the following year?
In 2020, as unemployment surged, the US S&P 500 still rose more than 16% for the year, and nearly 27% more in 2021. If you look only at the economy, it makes no sense. In this lesson we follow the 'amount of money', or liquidity, behind that scene.
MAPLearning map for this lesson
We build it up in three steps. At the end of each step, a 'Quick check' lets you test your understanding before moving on.
In Lesson 1 we briefly met 'liquidity', together with interest rates and sentiment, as a force that shakes the multiple (P/E). Here we build on the central bank in Lesson 13, market interest rates in Lesson 14, the bond seesaw in Lesson 15 and reading multiples in Lesson 37.
- STEP 1 · Basic conceptsLiquidity and the money supply
You can explain what and are, and why asset prices tend to rise when there is more money in the market.
- STEP 2 · Understanding the mechanicsThe two taps that release money
You can sketch how a central bank controls the amount and the price of money through interest rates and and .
- STEP 3 · Real-world applicationMoney flows, 2020–2026
Using Fed total assets and M2 data, you can read liquidity-driven rallies and reversals, and tell apart cases where liquidity alone cannot explain stock prices.
STEP 1Liquidity and the money supply
'Liquidity' comes up in the news all the time, but it is hard to explain when you try. Let's unpack it step by step with a water analogy.
Liquidity is the water level of money in the market
carries two overlapping meanings. One is 'how easily something can be turned into cash'; the other is 'how plentifully money is circulating in the market and the economy as a whole'. When economic news says "liquidity is abundant" or talks about a "liquidity-driven rally", it mostly means the second one. The more plentiful and easy to borrow money is, the more of it flows into assets such as stocks, real estate and crypto.
An easy analogy · the water level in a swimming pool
Imagine several inflatable rings floating in a pool. If you pour in more water, all the rings rise together, whatever their size. If you drain water, they all sink together. The rings have not actually become bigger. In markets too, when money is overflowing, prices (the height) tend to rise even if company earnings (the size of the ring) stay the same. In the words of Lesson 1, the 'multiple knob' is turned up.
Measuring the amount of money with M2
The standard gauge of the amount of money is (broad money). It adds savings deposits and small money market funds, which can be turned into cash quickly, to the cash in your wallet and demand deposits you can withdraw any time. US M2 is published monthly by the Fed, and Korean M2 by the Bank of Korea.
Money is not created by the central bank alone. When a bank makes a loan, that money comes back as someone's deposit, and that deposit becomes the raw material for another loan. So when the central bank cuts rates and lending grows, M2 grows fast; when it raises rates and lending shrinks, M2 growth slows. When reading the numbers in this lesson, we look less at the 'size' of M2 and more at 'how many percent it grew from a year ago', that is, the growth rate.
Quick checkCompany earnings stayed the same, but money flooded into the market and the stock price rose 30%. Which of the two knobs from Lesson 1 moved?
STEP 2The two taps that release money
The one who controls the water in the pool is the central bank. And the central bank has two taps.
The first tap: interest rates, the price of money
The policy rate you saw in Lesson 13 is the first tap. When the policy rate is cut, borrowing gets cheaper, so households and companies borrow more, and people whose deposit interest has shrunk move to stocks or bonds in search of higher returns. But as in the 2008 financial crisis and the 2020 COVID period, if rates are cut to nearly 0% and the economy still does not recover, there is no room to cut further. That is when the central bank turns to the second tap.
The second tap: quantitative easing and tightening, the amount of money
(QE) is a policy in which the central bank buys large amounts of government bonds or mortgage-backed securities in the market. When the central bank pays for the bonds, that money piles up as bank , and the investors who sold the bonds end up holding cash. At the same time, as in the Lesson 15 seesaw, stronger demand for bonds pushes bond prices up and long-term rates down. Investors holding cash move into riskier assets such as corporate bonds and stocks in search of higher returns.
(QT) is the exact opposite. The central bank stops buying again when its bonds mature, or sells them, and draws money out of the market. You can see this process in the size of the central bank's (total assets). Buying bonds raises total assets; reducing holdings lowers them.
See it in a picture: the path money takes
Press the buttons to switch between quantitative easing and quantitative tightening. Press 'Step by step' and the boxes light up in the order the money flows.
In reality there are lags of several months to several years between the steps, and the size of the effect varies greatly with economic conditions. This is a simplified picture to aid understanding.
Three channels through which liquidity lifts asset prices
To sum up, liquidity reaches asset prices through three channels. First, the interest rate channel. When long-term rates fall, the discount rate from Lesson 17 gets lower, the present value of future earnings grows, and the P/E rises. Second, the portfolio shift channel. Investors whose returns on safe bonds have shrunk move their money into riskier assets. Third, the sentiment channel. Once people believe that "the central bank will back the market", their appetite for risk grows. What matters is that all three channels mostly move the multiple knob.
Common misconceptions
- "If money is released, do stocks always rise?"
- No. In 2008 too, the Fed cut rates to nearly 0% and bought bonds, but stocks kept falling for a while as the financial system shook (Lesson 21). Even if money is released, it does not flow into asset prices unless people spend or invest it.
- "If the money supply grows, do prices rise right away?"
- There is a lag. US M2 grew sharply in 2020–2021, and inflation began to rise in 2021 and peaked at 9.1% in June 2022 (Lesson 8). Other factors such as supply chain problems and energy prices also played a part.
- "Do I only need to watch Korean liquidity for the Korean market?"
- The Fed's liquidity reaches Korea too, through the dollar and foreign money flows (Lessons 24, 27 and 32). That is why Korean investors also follow news about the Fed's balance sheet.
Quick checkThe Fed announced that it "will not buy again when its Treasuries mature". Is that quantitative easing or quantitative tightening? What happens to the Fed's total assets?
STEP 3Money flows, 2020–2026
Now let's check with real numbers. Put the Fed's total assets and the US M2 growth rate on one screen and you can see how the water level changed over the past ten years.
Fed total assets and M2 growth, 10 years
US Fed total assets (bars, trillions of dollars) and M2 year-over-year growth (line, %), at quarter-end
Tap a bar to see that quarter's numbers.
Source: FRED WALCL (Fed total assets, weekly, value of the last week of each quarter), M2SL (M2, monthly, year-over-year growth for the last month of each quarter, calculated by Robin Invest). Q3 2026 M2 is the August value. Checked 2026-10-05.
The chart contains three scenes. First, Fed total assets swelled about 67% in less than four months, from $4.24 trillion in the week of March 4, 2020 to $7.08 trillion at the end of June. M2 growth also soared to 26.8% in February 2021. This is the backdrop to the 'frozen economy and hot stock market' in the opening question. Second, total assets peaked at $8.97 trillion in the week of April 13, 2022, and began to fall when quantitative tightening started alongside rate hikes that year. M2 growth turned negative at the end of 2022 and fell to −4.6% in April 2023. Third, in March 2023, during the Silicon Valley Bank episode (Lesson 18), the Fed supplied emergency funds to banks and total assets briefly rose again.
And what did the S&P 500 do then?
Source: price change calculated from FRED SP500 year-end closes (2019–2023), excluding dividends. Checked 2026-10-05.
The of 2020–2021 and the reversal of 2022 fit the liquidity story well. But 2023 is different. With M2 shrinking and the Fed's total assets also falling, the S&P 500 still rose more than 24%. As seen in Lesson 17, this was because expectations that rate hikes were ending combined with expectations of AI-related earnings. It means liquidity is a big force that sets the water level, but sometimes the force of earnings, which makes the ring itself bigger, is stronger. In 2026, M2 growth has come back to the 5% range (5.7% in August), and the Fed's total assets have stalled at around $6.7 trillion.
In stocks: reading liquidity news
| News | Direction of liquidity | Where it mainly shakes things |
|---|---|---|
| "Fed expands Treasury purchases" | Increases | Falling long-term rates → often favorable for the multiples of growth stocks and long-term bonds. |
| "Quantitative tightening to speed up" | Decreases | Upward pressure on long-term rates → high-P/E assets tend to feel the strain first. |
| "M2 growth rebounds" | Increases | It can be a tailwind for asset prices, but also watch for concerns about inflation picking up again (Lesson 7). |
| "Short-term funding markets seize up, emergency liquidity supplied" | Mixed | Money is released, but it is also a sign of crisis. March 2023 was such a case. |
You can check the FOMC schedule in the Calendar, and the current rate and inflation phase in the Macro Map's current phase.
This is not always the case. The relationship between liquidity and stock prices varies greatly from period to period, and M2 or central bank total assets alone cannot predict the direction of stock prices. The content of this lesson is meant to explain a framework for reading the market and does not recommend buying or selling any particular asset.
Quick checkExplain, using the two knobs, why the S&P 500 rose more than 24% in 2023 even though M2 was shrinking.
✓What we learned today
- Liquidity refers both to 'the amount of money circulating in the market' and to 'how easily money can be obtained'. The main indicator is M2, the money supply that adds up cash, deposits and so on.
- The central bank adjusts the 'price' of money with the policy rate, and the 'amount' of money with quantitative easing (QE) and quantitative tightening (QT). QE buys bonds to release money; QT does the reverse and draws money back.
- When money is plentiful and rates are low, investors tend to move into risk assets and the multiple (P/E) tends to expand. US M2 growth in 2020–2021 soared to 26.8% in February 2021.
- When rate hikes and QT overlapped in 2022, M2 began to shrink from the end of 2022 and the S&P 500 fell 19.4%. In 2023, however, the index rose on earnings expectations even while M2 was shrinking.
- Liquidity is a big force moving the multiple knob, but not the only one. Look at it together with interest rates, earnings and sentiment.
When money overflows, people get giddy, and when money drains away, they get scared. In the next lesson, Lesson 39, you will learn the fear gauge VIX and the margin loan balance, which measure that mood in numbers.
Quiz5-question quiz
Pick an answer and it's graded right away with an explanation.
Q1. Which of the following is NOT included in the money supply M2?
M2 is the amount of money that can be used as cash in a short time, like cash and deposits. Stocks are not money but assets bought with money, so they are not included in M2.
Q2. When the policy rate is already close to 0%, what is the policy in which the central bank buys large amounts of government bonds to release more money?
Quantitative easing is a policy in which the central bank buys bonds to supply money to the market. The central bank's total assets grow and long-term rates tend to fall.
Q3. When liquidity becomes plentiful, which knob mainly affects stock prices?
When money is plentiful, the discount rate falls and investors move into risk assets, making it easier to put a higher multiple on the same earnings.
Q4. When were US Fed total assets at their largest?
According to FRED data, the Fed's total assets were largest in the week of April 13, 2022, at about $8.97 trillion. They then fell with rate hikes and quantitative tightening to about $6.74 trillion at the end of September 2026.
Q5. What does the case of the S&P 500 rising strongly in 2023 while M2 was shrinking tell us?
In 2020–2022 liquidity explained the movement of stock prices well, but in 2023 expectations that rate hikes were ending and expectations about earnings weighed more. It is important to build the habit of not judging by a single indicator.
NextTerms · Next lesson · Related tools
The amount of money released into the market, or how easily an asset can be converted into cash. When there is plenty of liquidity, asset prices tend to rise.
Interest rateInterest rateThe price of borrowing money. When rates rise, the present value of future earnings falls, which tends to lower stock multiples.
Policy ratePolicy rateThe policy interest rate set by a central bank (the Bank of Korea, the US Fed). It is the starting point for all other interest rates.
FedFed, US Federal Reserve SystemThe central bank of the United States. It sets the policy rate with the goals of price stability and maximum employment.
BondBondAn IOU issued by a government or company when it borrows money. It pays set interest and returns the principal at maturity. When interest rates rise, the price of bonds already issued falls.
P/EPrice-Earnings RatioShare price ÷ EPS. A multiple showing how many times one year's earnings the market pays for a share. It varies greatly with interest rates and investor sentiment.
M2 (broad money)M2 money supplyThe money supply obtained by adding to cash and demand deposits the money that can easily be turned into cash, such as savings deposits and small money market funds. It is mainly viewed as a year-over-year growth rate.
Quantitative easing (QE)Quantitative easingA policy in which the central bank buys large amounts of government bonds and the like to supply money to the market. It is mainly used when it is hard to cut the policy rate any further.
Quantitative tightening (QT)Quantitative tighteningA policy in which the central bank does not reinvest its bonds after they mature, or sells them, to draw money out of the market. The central bank's total assets shrink.
Central bank balance sheet (total assets)Central bank balance sheetThe size of the assets the central bank holds, such as government bonds and securities. It grows during quantitative easing and shrinks during quantitative tightening, showing the direction of liquidity. For the US, check FRED WALCL.
ReservesBank reservesMoney that banks keep deposited with the central bank. When the central bank buys bonds, the payment piles up as reserves, increasing the bank's capacity to lend.
Liquidity-driven rallyLiquidity-driven rallyA period in which abundant money and low rates, rather than improving earnings, drive stock prices up. 2020–2021 is the typical example, and when the money drains away, the market can be shaken just as sharply in the other direction.
This is educational material and not investment solicitation. There is no guarantee that past relationships will repeat in the future.