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Market Liquidity, Asset Prices, and Welfare

43 Pages Posted: 25 Aug 2007 Last revised: 11 Sep 2009

Jennifer C. Huang

University of Texas at Austin - Department of Finance

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: August 1, 2008

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.

Keywords: liquidity, transaction costs, asset prices, welfare

JEL Classification: D52, D62, G12

Suggested Citation

Huang, Jennifer C. and Wang, Jiang, Market Liquidity, Asset Prices, and Welfare (August 1, 2008). McCombs School of Business Research Paper No. FIN-05-08; AFA 2009 San Francisco Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1009568 or http://dx.doi.org/10.2139/ssrn.1009568

Jennifer Chunyan Huang (Contact Author)

University of Texas at Austin - Department of Finance ( email )

McCombs School of Business, B6600
Austin, TX 78712
United States
512-232-9375 (Phone)
512-471-5073 (Fax)

Jiang Wang

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E62-614
100 Main Street
Cambridge, MA 02142
United States
617-253-2632 (Phone)
617-258-6855 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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