Self-fulfilling liquidity dry-ups
AbstractSecondary markets for long-term assets might be illiquid due to adverse selection. In a model in which moral hazard is confined to project initiation, I find that: (1) when agents expect a liquidity dry-up on such markets, they optimally choose to self-insure through the hoarding of non-productive but liquid assets; (2) such a response has negative externalities as it reduces ex-post market participation, which worsens adverse selection and dries up market liquidity; (3) liquidity dry-ups are Pareto inefficient equilibria; (4) the Government can rule them out. Additionally, when agents face idiosyncratic, privately known, illiquidity shocks, I show that: (5) it increases market liquidity; (6) illiquid agents are better-off when they can credibly disclose their liquidity position, but transparency has an ambiguous effect on risk-sharing possibilities.
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Bibliographic InfoPaper provided by National Bank of Belgium in its series Working Paper Research with number 185.
Length: 44 pages
Date of creation: Mar 2010
Date of revision:
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Liquidity; Liquidity Dry-ups; Financial Crises; Hoarding; Adverse Selection; Self-insurance;
Find related papers by JEL classification:
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G01 - Financial Economics - - General - - - Financial Crises
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-03-13 (All new papers)
- NEP-CTA-2010-03-13 (Contract Theory & Applications)
- NEP-FDG-2010-03-13 (Financial Development & Growth)
- NEP-IAS-2010-03-13 (Insurance Economics)
- NEP-MAC-2010-03-13 (Macroeconomics)
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