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Liquidity and Congestion

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  • Gara Minguez Afonso

    (LSE / Princeton University)

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    Abstract

    This paper studies the relationship between the arrival of potential investors and market liquidity in a search-based model of asset trading. The entry of investors into a specific market causes two contradictory effects. First, it reduces trading costs, which then attracts new investors (thick market externality effect). But secondly, as investors concentrate on one side of the market, the market becomes “congested”, decreasing the returns to participating in this market and discouraging new investors from entering (congestion effect). The equilibrium level of market liquidity depends on which of the two effects dominates. When congestion is the leading effect, some interesting results arise. In particular, we find that diminishing trading costs in our market can deteriorate liquidity and reduce welfare.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 926.

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    Date of creation: 2008
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    Handle: RePEc:red:sed008:926

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    1. Guillaume Plantin, 2004. "Self-Fulfilling Liquidity and the Coordination Premium," GSIA Working Papers 2005-E3, Carnegie Mellon University, Tepper School of Business.
    2. Dimitri Vayanos, 1998. "Transaction costs and asset prices : a dynamic equilibrium model," LSE Research Online Documents on Economics 451, London School of Economics and Political Science, LSE Library.
    3. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society.
    4. Acharya, Viral V & Pedersen, Lasse Heje, 2004. "Asset Pricing with Liquidity Risk," CEPR Discussion Papers 4718, C.E.P.R. Discussion Papers.
    5. Ricardo Lagos & Guillaume Rocheteau, 2009. "Liquidity in Asset Markets With Search Frictions," Econometrica, Econometric Society, vol. 77(2), pages 403-426, 03.
    6. Vayanos, Dimitri & Weill, Pierre-Olivier, 2006. "A Search-Based Theory of the On-the-Run Phenomenon," CEPR Discussion Papers 5965, C.E.P.R. Discussion Papers.
    7. P. Diamond, 1980. "Aggregate Demand Management in Search Equilibrium," Working papers 268, Massachusetts Institute of Technology (MIT), Department of Economics.
    8. Pagano, Marco, 1989. "Trading Volume and Asset Liquidity," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 255-74, May.
    9. Vayanos, Dimitri & Wang, Tan, 2007. "Search and endogenous concentration of liquidity in asset markets," Journal of Economic Theory, Elsevier, vol. 136(1), pages 66-104, September.
    10. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    11. Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.
    12. Milgrom, Paul & Roberts, John, 1990. "Rationalizability, Learning, and Equilibrium in Games with Strategic Complementarities," Econometrica, Econometric Society, vol. 58(6), pages 1255-77, November.
    13. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
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    Cited by:
    1. Pierre-Olivier Weill & Bruno Biais, 2009. "Liquidity shocks and order book dynamics," 2009 Meeting Papers 89, Society for Economic Dynamics.
    2. Pierre-Olivier Weill & Guillaume Rocheteau & Ricardo Lagos, 2010. "Crises and Liquidity in Over-the-counter Markets," 2010 Meeting Papers 500, Society for Economic Dynamics.

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