Liquidity Freezes Under Adverse Selection
53 Pages Posted: 1 Apr 2014 Last revised: 9 Jul 2016
Date Written: June 2016
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: Suggested Citation