The State-Contingent Link between Market Illiquidity and Economic Growth

24 Pages Posted: 17 Feb 2013

See all articles by Alan Rai

Alan Rai

Macquarie University, Macquarie Business School; Financial Research Network (FIRN)

Date Written: December 18, 2012

Abstract

I examine the ability of U.S. equity and bond market illiquidity to predict U.S. macroeconomic variables, between 1946 and 2010. In contrast to existing studies, I allow for illiquidity's predictive ability to be state contingent, using a Markov regime switching model. I uncover strong evidence that the predictive power of equity market illiquidity is state-contingent, with much higher predictability in states associated with historical periods of economic and financial stress. Furthermore, economic growth forecasts from Markov regime switching models that include market liquidity in the set of predictor variables are statistically better than forecasts from Markov switching models that exclude liquidity.

Keywords: autoregression, bid-ask spread, economic growth, forecasts, regime switching, trading volume

JEL Classification: G12, G14, G17

Suggested Citation

Rai, Alan, The State-Contingent Link between Market Illiquidity and Economic Growth (December 18, 2012). Available at SSRN: https://ssrn.com/abstract=2219527 or http://dx.doi.org/10.2139/ssrn.2219527

Alan Rai (Contact Author)

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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