Free-Riding on Liquidity

University of Zurich Economics Working Paper No. 32

30 Pages Posted: 9 Nov 2011 Last revised: 22 Dec 2012

See all articles by Aleksander Berentsen

Aleksander Berentsen

University of Basel - Faculty of Business and Economics; CESifo (Center for Economic Studies and Ifo Institute)

Samuel Huber

University of Basel

Alessandro Marchesiani

University of Bath - Department of Economics

Date Written: September 30, 2011

Abstract

Do financial market participants free-ride on liquidity? To address this question, we construct a dynamic general equilibrium model where agents face idiosyncratic preference and technology shocks. A secondary financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The opportunity to do so reduces the demand for the liquid asset and, hence, its value. The optimal policy response is to restrict (but not eliminate) access to the secondary financial market. The reason for this result is that the portfolio choice exhibits a pecuniary externality: An agent does not take into account that by holding more of the liquid asset, he not only acquires additional insurance but also marginally increases the value of the liquid asset which improves insurance to other market participants.

Keywords: Monetary Policy, liquidity, financial markets

JEL Classification: E52, E58, E59

Suggested Citation

Berentsen, Aleksander and Huber, Samuel and Marchesiani, Alessandro, Free-Riding on Liquidity (September 30, 2011). University of Zurich Economics Working Paper No. 32, Available at SSRN: https://ssrn.com/abstract=1957152 or http://dx.doi.org/10.2139/ssrn.1957152

Aleksander Berentsen (Contact Author)

University of Basel - Faculty of Business and Economics ( email )

Petersplatz 1
Basel, 4001
Switzerland

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Samuel Huber

University of Basel ( email )

Petersplatz 1
Basel, CH-4003
Switzerland

Alessandro Marchesiani

University of Bath - Department of Economics ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom

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