Inefficient Liquidity Provision
27 Pages Posted: 22 Feb 2017 Last revised: 1 Mar 2017
Date Written: February 22, 2017
We prove that in competitive market economies with no insurance for idiosyncratic risks, agents will always overinvest in illiquid long term assets and underinvest in short term liquid assets. We take as our setting the seminal model of Diamond and Dybvig (1983), who first posed the question in a tractable model. We reach such a simple conclusion under mild conditions because we stick to the basic competitive market framework, avoiding the banks and intermediaries that Diamond and Dybvig and others introduced.
Keywords: Liquidity, Constrained inefficiency, Diamond-Dybvig models, fire sales
JEL Classification: E44, D5, E43, E6, G18
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