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A theory of procyclical market liquidity

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  • Strobl, Günter

Abstract

This paper presents a theory of liquidity cycles based on endogenous fluctuations in economic activity and the availability of informed capital. Risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets depends on the endogenous information structure in the market. Liquidity provision is modeled as a repeated game with imperfect public monitoring. We construct a trigger-strategy equilibrium along the lines of Green and Porter (1984) that is characterized by stochastic fluctuations in liquidity. Liquidity is procyclical in our economy. Periods of economic growth are associated with more liquid asset markets.

Suggested Citation

  • Strobl, Günter, 2022. "A theory of procyclical market liquidity," Journal of Economic Dynamics and Control, Elsevier, vol. 138(C).
    • Handle: RePEc:eee:dyncon:v:138:y:2022:i:c:s0165188922000318
    DOI: 10.1016/j.jedc.2022.104326
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    More about this item

    Keywords

    Market liquidity; Adverse selection; Business cycle; Repeated game;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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