Working Paper: NBER ID: w17876
Authors: Veronica Guerrieri; Robert Shimer
Abstract: We develop a dynamic equilibrium model of asset markets affected by adverse selection. There exists a unique equilibrium where better assets trade at higher prices but in less liquid markets. Sellers of high-quality assets can separate because they are more willing to accept a lower trading probability. As a result, the emergence of adverse selection generates a drop in liquidity. It may also lead to a decline in the price-dividend ratio--a fire sale--and a flight to quality. Subsidies to purchasing assets may be Pareto improving and can reverse the fire sale and flight to quality.
Keywords: adverse selection; liquidity; fire sales; flight to quality
JEL Codes: D82; E44; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse selection (D82) | decline in market liquidity (G10) |
| decline in market liquidity (G10) | higher-quality assets trade at lower prices (G12) |
| adverse selection (D82) | fire sales (G33) |
| fire sales (G33) | decline in asset prices (G19) |
| adverse selection (D82) | decline in expected revenue from sales of higher-quality assets (G19) |
| subsidies for purchasing assets (H25) | improve liquidity (G33) |