Working Paper: NBER ID: w2641
Authors: Sanford J. Grossman; Merton H. Miller
Abstract: Market liquidity is modeled as being determined by the demand and supply of immediacy. Exogenous liquidity events coupled with the risk of delayed trade create a demand for immediacy. Market makers supply immediacy by their continuous presence. and willingness to bear risk during the time period between the arrival of final buyers and sellers. In the long run the number of market makers adjusts to equate the supply and demand for immediacy. This determine the equilibrium level of liquidity in the market. The lower is the autocorrelation in rates of return, the higher is the equilibrium level of liquidity.
Keywords: Market Liquidity; Market Structure; Market Makers; Immediacy
JEL Codes: G10; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| liquidity events (G14) | demand for immediacy (E41) |
| demand for immediacy (E41) | market makers adjust their numbers (G19) |
| market makers adjust their numbers (G19) | liquidity (E41) |
| lower autocorrelation in price returns (C22) | higher equilibrium liquidity (D53) |
| costs for market makers decrease (D41) | liquidity improves (G33) |