This is a hard question to answer. TH likes to think about liquidity describing the ease with which a transaction can be reversed (i.e. as a description of the state of a market). When liquidity is good, a transaction can readily be reversed at the market price that the transaction took place at (assuming that there have been no changes to the underlying demand and supply conditions).
With respect to the housing market, sometimes it is easy to buy and sell a house (meaning that the transaction can be fairly easily reversed and houses are fairly liquid). Of course you may not be able to sell a house and then buy the exact same house back again, but, if market liquidity is good, you could buy back a house with essentially the same attributes for pretty much the same price as you sold the first one for. On the other hand, sometimes the housing market is slow, you may find a house to buy, but it could be quite difficult to sell what is essentially the same house at the same price that you bought the first for so houses are illiquid.
So what determines the liquidity of the housing market? Money goes a long way, because it reduces the need for barter. To paraphrase Robert Clower – “houses buy money and money buys houses, but houses don’t buy houses.” But that is a somewhat, though not entirely, uninteresting answer. What TH wants to think about is what causes churning in owner occupied housing markets. The more churning in the market (i.e. the more people looking to buy and sell a home), the greater the chances people can make transactions that are relatively reversible and the more liquid the market will be.
There are two main sources of churning. The first is demographics – kids leaving their parents’ homes for their own, which ultimately means churning of the housing stock from the old to the young. Call this sort of market participant a Type 1 churner. The second source of churning occurs when some event makes a household’s current house unsatisfactory relative to their needs requiring them to want to switch homes. Call this group Type II churners.
Consider a market with only switchers (Type IIs) in it. If you assume that switchers are not prepared to go homeless, then when a switcher decides to sell their home and buy another, they will either have to find another home that settles on the exact same day, or they will need to carry two properties for a period of time. When they have two properties, it means that one property is, for all intents and purposes, vacant. It turns out that the supply and demand for this vacant housing is key to understanding housing market liquidity.
In the short-run, because the supply of houses is more or less fixed and the number of households (people living in houses) is also fixed, the number of vacant homes (inventory for lack of a better word) must be fixed as well. So everything then depends on the demand for the vacant housing stock.
An example might help. Imagine what happens when there is some shock to the market that lowers the cost of holding a second house, such as a cut in interest rates for example. There are two offsetting effects to consider. First, on one hand, when the cost of holding a vacant house decreases, the number of market participants willing to switch houses will go up, on the other hand, the period that they are willing to carry the vacant house also goes up. Both can’t happen. But because both represent an increase in demand for houses, the unambiguous effect is that the price people are willing to pay for the use for a house as inventory will increase. In a competitive market, that means that the price of housing in general also rises.
The effect on liquidity, however, depends on whether the resulting equilibrium involves more participants churning through the stock of vacant houses quickly, or fewer households using the inventory to extend their house search for longer.
When individuals hold on to the vacancy for an extended period, they reduce the supply of the pool of vacant houses available to others and drive participants out of the market and reduce liquidity. This effect could be termed the liquidity using (or draining) effect. On the other hand, if more people enter the market, with each searching for less time, but contributing to turnover and a greater variety of houses, then there is a liquidity creating or enhancing effect.
Which of the two effects dominates is not clear. But because a more liquid market is more attractive to both buyers and sellers, it will attract even pore entrants, and put additional pressure on prices. On the other hand a less liquid market will be less attractive and alleviate pressure on prices. What this means is that a shock to demand caused by a cut in interest rates, for example, would almost certainly cause housing prices to rise, but it could cause either an increase in housing market liquidity (i.e. a hot market where Flip that House shows on prime time TV) or a slowing housing market, where despite lower interest rates and high prices, homes a slow to sell.