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Liquidity and congestion

  • Gara M. Afonso

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 (the thick market externality effect). But second, 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 (what we call the 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 impair liquidity and reduce welfare.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 349.

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Date of creation: 2008
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Handle: RePEc:fip:fednsr:349
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  1. Pagano, Marco, 1989. "Trading Volume and Asset Liquidity," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 255-74, May.
  2. Viral V. Acharya & Lasse Heje Pedersen, 2004. "Asset Pricing with Liquidity Risk," NBER Working Papers 10814, National Bureau of Economic Research, Inc.
  3. Guillaume Plantin, 2004. "Self-Fulfilling Liquidity and the Coordination Premium," GSIA Working Papers 2005-E3, Carnegie Mellon University, Tepper School of Business.
  4. James Dow, 2004. "Is Liquidity Self-Fulfilling?," The Journal of Business, University of Chicago Press, vol. 77(4), pages 895-908, October.
  5. Brunnermeier, Markus K & Pedersen, Lasse Heje, 2007. "Market Liquidity and Funding Liquidity," CEPR Discussion Papers 6179, C.E.P.R. Discussion Papers.
  6. Amihud, Yakov & Mendelson, Haim & Pedersen, Lasse Heje, 2006. "Liquidity and Asset Prices," Foundations and Trends(R) in Finance, now publishers, vol. 1(4), pages 269-364, February.
  7. Diamond, Peter A, 1982. "Aggregate Demand Management in Search Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 90(5), pages 881-94, October.
  8. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
  9. Dmitrios Vayanos, 2004. "Search and Endogenous Concentration of Liquidity in Asset Markets," Econometric Society 2004 North American Winter Meetings 647, Econometric Society.
  10. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in asset markets: market structure, liquidity, and welfare," Working Paper 0701, Federal Reserve Bank of Cleveland.
  11. Dimitri Vayanos & Pierre-Olivier Weill, 2008. "A Search-Based Theory of the On-the-Run Phenomenon," Journal of Finance, American Finance Association, vol. 63(3), pages 1361-1398, 06.
  12. Weill, Pierre-Olivier, 2008. "Liquidity premia in dynamic bargaining markets," Journal of Economic Theory, Elsevier, vol. 140(1), pages 66-96, May.
  13. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2006. "Valuation in Over-the-Counter Markets," NBER Working Papers 12020, National Bureau of Economic Research, Inc.
  14. Diamond, Peter A, 1982. "Wage Determination and Efficiency in Search Equilibrium," Review of Economic Studies, Wiley Blackwell, vol. 49(2), pages 217-27, April.
  15. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
  16. Pissarides, Christopher A, 1985. "Short-run Equilibrium Dynamics of Unemployment Vacancies, and Real Wages," American Economic Review, American Economic Association, vol. 75(4), pages 676-90, September.
  17. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004. "Over-the-Counter Markets," NBER Working Papers 10816, National Bureau of Economic Research, Inc.
  18. Ricardo Lagos & Guillaume Rocheteau, 2007. "Liquidity in asset markets with search frictions," Working Paper 0706, Federal Reserve Bank of Cleveland.
  19. Milgrom, Paul & Roberts, John, 1990. "Rationalizability, Learning, and Equilibrium in Games with Strategic Complementarities," Econometrica, Econometric Society, vol. 58(6), pages 1255-77, November.
  20. James J. McAndrews & Simon M. Potter, 2002. "Liquidity effects of the events of September 11, 2001," Economic Policy Review, Federal Reserve Bank of New York, issue Nov, pages 59-79.
  21. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 11(1), pages 1-58.
  22. 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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