What Is the Mechanism by Which Excess Cash Yields Excess Prices?
Introduction (Via JBF)
It has become an article of faith that the “invisible hand” of the free market sets prices with the collective wisdom of the body of traders. The success of the free market in providing stable consumer prices has enhanced the confidence in this idea. Within a very abstract sense, the price theory of consumer goods is similar to that of financial assets. Both are set by supply and demand for the item. Yet there is a profound difference between the two in that financial assets are often bought with the sole purpose of selling at a higher price later, while consumers rarely buy for that reason. For the consumer, the market offers a local optimization problem. A consumer must exercise a relative preference for different items each of which provides some utility. Modern portfolio theory is based largely upon the idea that one purchases a portfolio of stocks, bonds and other financial instruments in a similar way, by using a utility function that balances reward with risk, just as a consumer balances expenses with needs and
Thoughts (Via JBF)
An important link between available cash and the price inflation can be studied retrospectively in terms of this period, and presumably linked to the concept of excess cash as in the experimental markets. In this way one can test the hypothesis that excess cash allows the fringe to dominate the market and thereby allow the most exaggerated psychological characteristics to set market prices. For example, the effects of overreaction may be difficult to see on the upside when there is little cash but become dominant when the market is flush with cash. Experimental asset markets with asymmetry can be useful in understanding the effect of excess cash on the behavior and strategy of participants. The effect of excess cash may be important in terms of understanding psychological effects since theories can be carefully constructed through repeatable experiments and then tested with the data of this historic period.