What is a likely effect of an unstable economic environment on liquidity?

In an unstable economic environment, one likely effect is the reduced availability of cash and credit. This is primarily due to heightened risk aversion among lenders and investors. In uncertain economic conditions, financial institutions may tighten their lending standards, making it more difficult for businesses and individuals to obtain loans. Additionally, businesses may hoard cash rather than invest or expand due to concerns about the future, leading to a decrease in overall liquidity in the market.

Furthermore, during periods of economic instability, confidence in financial markets generally wanes, leading to reduced trading volumes and higher volatility. This combination tends to result in liquidity drying up, as both lenders and borrowers become more cautious. Thus, the environment fosters conditions where cash and credit become scarce, which aligns with the conclusion that liquidity is negatively affected.