Liquidity and Congestion

44 Pages Posted: 20 Oct 2008 Last revised: 8 Jun 2010

See all articles by Gara Afonso

Gara Afonso

Federal Reserve Bank of New York

Date Written: February 15, 2009

Abstract

This paper studies the relationship between the arrival of potential investors and market liquidity in a search-based model of asset trading. The entry of investors into a specific market causes two contradictory effects. First, it reduces trading costs, which then attracts new investors (the thick market externality effect). But second, as investors concentrate on one side of the market, the market becomes "congested," decreasing the returns to participating in this market and discouraging new investors from entering (what we call the congestion effect). The equilibrium level of market liquidity depends on which of the two effects dominates. When congestion is the leading effect, some interesting results arise. In particular, we find that diminishing trading costs in our market can impair liquidity and reduce welfare.

Keywords: liquidity, search, congestion, asset pricing

JEL Classification: G12, D40

Suggested Citation

Afonso, Gara, Liquidity and Congestion (February 15, 2009). FRB of New York Staff Report No. 349. Available at SSRN: https://ssrn.com/abstract=1284592 or http://dx.doi.org/10.2139/ssrn.1284592

Gara Afonso (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

HOME PAGE: http://nyfedeconomists.org/afonso

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