Market Liquidity, Asset Prices and Welfare
Jennifer C. Huang
University of Texas at Austin - Department of Finance
Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)
NBER Working Paper No. w14058
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
Date posted: June 9, 2008