Working Paper: NBER ID: w14058
Authors: Jennifer Huang; Jiang Wang
Abstract: This paper presents an equilibrium model for the demand and supply of liquidity and its impact on asset prices and welfare. We show that when constant market presence is costly, purely idiosyncratic shocks lead to endogenous demand of liquidity and large price deviations from fundamentals. Moreover, market forces fail to lead to efficient supply of liquidity, which calls for potential policy interventions. However, we demonstrate that different policy tools can yield different efficiency consequences. For example, lowering the cost of supplying liquidity on the spot (e.g., through direct injection of liquidity or relaxation of ex post margin constraints) can decrease welfare while forcing more liquidity supply (e.g., through coordination of market participants) can improve welfare.
Keywords: Market Liquidity; Asset Prices; Welfare
JEL Codes: E44; E58; G12; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| idiosyncratic shocks (D89) | liquidity demand (E41) |
| liquidity demand (E41) | asset prices (G19) |
| market inefficiencies (G14) | welfare implications (I30) |
| lowering cost of supplying liquidity (E51) | welfare (I38) |
| coordinated liquidity supply (E51) | welfare (I38) |
| liquidity needs (E41) | price volatility (G13) |