Article first published online: 10th January 2018 DOI: 10.1111/jofi.12606
This paper proposes a theory of liquidity dynamics. Illiquidity results from asymmetric information. Observing the historical track record teaches agents how to interpret public information and helps overcome information asymmetry. However, an illiquidity trap can arise: too much asymmetric information leads to the breakdown of trade, which interrupts learning and perpetuates illiquidity. Liquidity falls in response to unexpected events that lead agents to question their valuation models (especially in newer markets) may be slow to recover after a crisis, and is higher in periods of stability.