A few weeks ago, Mr. Amihud, Prof. of Finance at Stern School, hold a lecture on asset prices and liquidity at Hohenheim. One of his main research findings were that liquiditiy does affect the valuation and pricing of assets. When liquidity affects prices, we may refer to Keynes and his liquidity preference theory. I found some interest passages in Keynes' research work.
Keynes(1937) writes that our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concering future. In so far we can conclude that the liqudity premium measures the extent of uncertainty in the economy. Keynes (1936) goes further and concludes that the difference corresponding to the difference between the best estimates we can make of probabilities and the confidence with which we make them is the difference between risk premium and liquditiy premium.
According to finance literature, market liquidity is ensured by market makers whose task is to bridge asynchronous asset orders in terms of purchases or sales. Now the market maker activity is less important the higher the trading volumes on markets (turnover)., i.e. the more investors are active in the markets for trading purposes.
Increasing misconfidence in estimates of future asset prices and economic outcomes triggers a decline in an asset's liquidity premium and lowers its price. Investors, thus, require higher return premia to buy the assets. Amihud's work shows that declining liquiditiy premium on part of assets goes hand in hand with an increased need of market maker activity.
We could see this effects recently on international money markets, where the central banks had to take over the role of market makers. This was so because the stabilizing forces of speculation which rely on divergent believes of the general public were not enough to stabilize markets. Therefore, we can see a clear link between asset valuation, liquiditiy and speculation.
@ all of those who want to go further in describing the deep causes of boom and busts. Yes, I do believe that fresh money creates nominal bubbles on asset markets. This is way there are so many traders trying to make profit on the wave and drive trading volumina and prices up. Massive liqudity is one reason why liquditiy premia of asstes rise (i.e. higher prices) and is already the trigger of the following bust (I use the term liquiditiy premium not only for money but also for any other asset. It is a measure of the likelihood and confidence to which extend future asset's cahs flow streams are save and can be quikely converted into money funds.)
