Sentiment, Liquidity and Asset Prices

We study a dynamic asset market, in which asset owners (i) are privately informed about the quality of their assets and (ii) experience occasional liquidity needs that give rise to gains from asset trade. The important feature of our setting is that although asset prices are always equal to fundamentals, the fundamentals themselves depend on asset prices through their effect on how efficiently assets are allocated. When the perceived quality of assets in the market is sufficiently low, the equilibrium features a ``market freeze'': only low quality assets trade at the lowest possible price. On the other hand, when the perceived quality of assets is sufficiently high, the equilibrium features ``efficient trade'': high and low quality assets trade at the highest possible price. Finally, for intermediate asset quality, there is equilibrium multiplicity and asset prices are driven by ``market sentiment.'' There is a rich set of equilibria, in which asset prices fluctuate due to sunspots, resembling what one may refer to as ``bubbles.''