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I'm trying to find/create a variable that measures liquidity in financial markets in order to assess, for instance whether credit conditions tightened? Does anyone know any relevant literature concerning this subject?

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There are many different options. The Fed has a Senior Loan office survey of whether credit conditions have tightened or loosened. Macroeconomic forecasters often use this as part of U.S. GDP forecasting models. Other market-based variables, such as VIX and the spread between various bonds, to get a sense of financial conditions.

There are also some financial conditions indices out there. The Chicago Fed and Bloomberg both come to mind. Doesn't really make sense to re-invent the wheel, but if you need a longer history you can look at their methodology to get a sense of what they're doing.

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  • $\begingroup$ Thanks a lot John! That's exactly the point, I am trying to get data since 1980 thus I'll take a look on those variables you've just mentioned $\endgroup$ – goncalogc Sep 30 '14 at 8:41
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Turnover ratio (TR) is one of the variables used. $TR_t=\frac{Total_. shares_. traded_. at_. time_. t}{Market_. capitalisation}$. This variable indicates the number of shares traded in a day. Liquidity is a tricky area and you will find various measures in various papers according the authors preference. I do not recommend directly using volume or market cap. These variables does not give relative comparison.

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Turnover ratio does not quite cut it because high liquidity is not the same as high trading activity. A nicer definition is how sensitive is the price to a given volume that is bid or offered. For that, check out this paper.

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