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I'm basically looking at this chart:

enter image description here

At first glance, I'm not sure it's clear as to why excess liquidity (money supply growth less GDP growth) is charted a whole 12 months ahead in the series. I could only assume it had something to do with contracts and other legal frictions. However, I think most supply chains and other real-economy type of contractual arrangements are longer than one year -- at least historically. Plus not all contracts are on the same date; contracts are beginning and ending all the time, so maybe it's not about contracts at all. Ergo I would like to explore the justifications for excess liquidity to be pushed forward 12 months -- and why 12 in particular. To me, it just seems a bit spurious, but that's perhaps because I don't have the intuition just yet.

Question

What is the justification for excess liquidity being a leading indicator of market performance, and a lengthy 12-month one at that? (I understand the context of chart design, makes it look nice, but there should be some theory that underpins the aesthetics/correlation when we move the series 12 months forward).

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Excess liquidity is provided in order for it to have an effect in the economy. They probably considered 12 months to be a reasonable average delay for the effects in economic growth to materialize.

In lay terms, they expected to see changes in economic growth 12 months after adjusting for liquidity, so they shifted the graph accordingly.

I believe that the resulting economic growth should be short term, and thus the real benefit for such a policy is to have a more stable and predictable performance, which does have long term positive effects.

The reason for liquidity leading to growth probably has to do with liquidity activating the economy: There are transactions that are not happening because there is not enough capital available (which might be available after saving, for example). However, only so much liquidity can be injected before we start seeing inflation and other adverse effects.

So liquidity needs to be provided carefully and with a clear plan of action for the future (will it be withdrawn? How much?).

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    $\begingroup$ I imagine that deciding on a better lag/lead than 12 months would be an analysis on its own. $\endgroup$
    – one_teach_wonder
    Feb 24, 2022 at 23:53

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