This is a Sunday morning [evening - I hesitated] post, about some ideas I'm playing around with, trying to get my head straight. I'm just throwing it out there, and wondering if it has enough empirical "oomph" to fly. I don't think there's anything original here. "It's all in Menger". But Menger didn't draw a pretty picture.
1. The more liquid is an asset, the more willing people will be to buy it or sell it, and so the quicker will be its velocity of circulation (the more times per year it will change hands). Example: if used cars were more liquid, because you could spot lemons easily, temporary visitors might buy a car and sell it next week instead of renting a car for a week.
2. The quicker the velocity of circulation of an asset, the greater the amount being traded in any period, the more easy it will be to find a buyer or seller quickly, and so the greater will be the liquidity of that asset. Example: if everybody traded for a newer model every year, the market for used cars would be much thicker, and so it would be a lot easier to find a buyer or seller for a particular model and year and colour of car.
3. Putting 1 and 2 together, we get a positive-feedback loop between liquidity and velocity. And positive feedback loops create multiplier effects. A small exogenous change in liquidity or velocity will cause a large change in equilibrium liquidity and velocity. Like in this picture:
4. The equilibrium (desired) rate of return on an asset will be inversely related to its liquidity, and the equilibrium price of an asset will be inversely related to its rate of return, so the price of an asset will be positively related to its liquidity.
5. Putting 3 and 4 together, small exogenous changes in the liquidity or velocity of assets will cause large changes in equilibrium velocities, liquidities, and asset prices. Financial crises look a lot like that.
6. Menger's theory of money is just an extreme case of 3. A positive feedback loop with positive feedback greater than one causes a snowball in which one good becomes more liquid than any other good, and so it becomes the medium of exchange. All other goods are traded for money, and so money has a higher velocity of circulation than any other good. The race to be the most liquid good is a winner-takes-all race, in which all other goods are traded for the winner. We define the liquidity of all other assets as the ease with which they can be bought and sold for money.
7. If those positive feedback effects are big enough we can get multiple equilibria, and self-fullfilling expectations. Assets markets might dry up and asset prices drop for no reason at all.
8. If all other goods became less liquid, that would increase the demand for money. People would hold more money while waiting longer for an opportunity to buy some other asset, and would hold more money if they expected to have to wait longer for an opportunity to sell some other asset.
9. And if the demand for money increases, but the central bank does not increase the supply of money in proportion, and if prices are sticky, the result will be a recession.
10. Recessions create another positive feedback loop. Because it is harder to sell goods that are in excess supply, so they become less liquid. And because some previously safe assets will become risky lemons, which makes them less liquid.