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Market Liquidity, Asset Prices, and WelfareJennifer C. HuangUniversity of Texas at Austin - Department of Finance Jiang WangMassachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER) August 1, 2008 McCombs School of Business Research Paper No. FIN-05-08 AFA 2009 San Francisco Meetings Paper Abstract: This paper presents an equilibrium model for the demand and supply of liquidity and its impact on asset prices and welfare. We show that when constant market presence is costly, purely idiosyncratic shocks lead to endogenous demand of liquidity and large price deviations from fundamentals. Moreover, market forces fail to lead to efficient supply of liquidity, which calls for potential policy interventions. However, we demonstrate that different policy tools can yield different efficiency consequences. For example, lowering the cost of supplying liquidity on the spot (e.g., through direct injection of liquidity or relaxation of ex post margin constraints) can decrease welfare while forcing more liquidity supply (e.g., through coordination of market participants) can improve welfare.
Number of Pages in PDF File: 43 Keywords: liquidity, transaction costs, asset prices, welfare JEL Classification: D52, D62, G12 working papers seriesDate posted: August 25, 2007 ; Last revised: September 11, 2009Suggested CitationContact Information
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