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Liquidity Freezes Under Adverse Selection

53 Pages Posted: 1 Apr 2014 Last revised: 9 Jul 2016

José Jorge

Universidade do Porto, Faculdade de Economia. CEF.UP

Charles M. Kahn

University of Illinois, Urbana-Champaign; Feseral Reserve Bank of Saint Louis; Bank of Canada

Date Written: June 2016

Abstract

This paper analyses how adverse selection prevents liquidity from flowing from liquid to illiquid firms, thus impairing the transmission mechanism of policy. Contrary to the results in the literature, simply increasing the availability of liquidity does not solve the adverse selection problem. When there are aggregate shocks, authorities face a policy dilemma if their single policy tool is to manipulate the price of liquidity. We consider alternative policies which address the problem in a time-consistent fashion.

Keywords: liquidity; adverse selection; funding liquidity risk; financial market freezes

JEL Classification: E44, E52, G28

Suggested Citation

Jorge, José and Kahn, Charles M., Liquidity Freezes Under Adverse Selection (June 2016). Available at SSRN: https://ssrn.com/abstract=2419170 or http://dx.doi.org/10.2139/ssrn.2419170

José Jorge (Contact Author)

Universidade do Porto, Faculdade de Economia. CEF.UP ( email )

Faculdade Economia
Rua Dr Roberto Frias
Porto, 4200-464
Portugal
+351 225 571 100 (Phone)
+351 225 505 050 (Fax)

HOME PAGE: http://https://sigarra.up.pt/fep/pt/FUNC_GERAL.FORMVIEW?p_codigo=235892

Charles M. Kahn

University of Illinois, Urbana-Champaign ( email )

Department of Finance
340 Wohlers Hall
Champaign, IL 61820
United States

HOME PAGE: http://kahnfrance.com/cmk/

Feseral Reserve Bank of Saint Louis

411 Locust St
Saint Louis, MO 63011
United States

Bank of Canada

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

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