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Market Freeze and Recovery: Trading Dynamics under Optimal Intervention by a Market-Maker-of-Last-Resort

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Author Info

  • Thorsten V. Koeppl

    (Queen’s University)

  • Jonathan Chiu

    (Bank of Canada)

Abstract

In the context of a search model of asset trading with adverse selection, we demonstrate that trading of a financial asset will cease, when its average quality drops sufficiently. A large player, however, can establish trading again, if he removes a sufficiently large quantity of bad assets which involves assuming losses. Most importantly, we show that such a player does not have to intervene immediately: a mere announcement today of intervening in the future can cause markets to function again. This announcement effect gives rise to a trade-off between the size and the timing of the intervention. The optimal policy balances the (social) costs of transfers against the costs of illiquid markets. If the former are small, it is optimal to ensure that markets function continuously. This is optimally achieved by intervening immediately, but at a minimum scale. When the costs of transfers increase, it is however optimal to delay the intervention and increase its size.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 78.

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Date of creation: 2010
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Handle: RePEc:red:sed010:78

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Cited by:
  1. Derek Stacey, 2011. "Tenure Insecurity, Adverse Selection, and Liquidity in Rural Land Markets," Working Papers 1269, Queen's University, Department of Economics.
  2. Robert Shimer & Veronica Guerrieri, 2013. "Markets with Multidimensional Private Information," 2013 Meeting Papers 210, Society for Economic Dynamics.
  3. Hajime Tomura, 2012. "Asset Illiquidity and Market Shutdowns in Competitive Equilibrium," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(3), pages 283-294, July.
  4. Koralai Kirabaeva, 2010. "Adverse Selection, Liquidity, and Market Breakdown," Working Papers 10-32, Bank of Canada.
  5. Veronica Guerrieri & Robert Shimer, 2012. "Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality," NBER Working Papers 17876, National Bureau of Economic Research, Inc.
  6. Briana Chang, 2011. "Adverse Selection and Liquidity Distortion in Decentralized Markets," 2011 Meeting Papers 157, Society for Economic Dynamics.

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