43 Pages Posted: 25 Aug 2007 Last revised: 11 Sep 2009
Date Written: August 1, 2008
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: 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