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Liquidity and the Business Cycle


  • Naes, Randi

    (Ministry of Industry)

  • Skjeltorp, Johannes

    (Norges Bank)

  • Odegaard, Bernt Arne

    () (University of Stavanger)


We show evidence of a contemporaneous relation between stock market liquidity and the business cycle. Stock market liquidity worsen when the economy is slowing down, and vice versa. This effect is most pronounced for small firms. Using data for both the US and Norway, we find strong evidence that stock market liquidity predict the current and future state of the economy. We also show some evidence that can shed light on the link between stock markets and the real economy. Using stock ownership data from Norway, we find that the portfolio compositions of investors change with the business cycle. Our results suggests a flight to quality during economic downturns where equity traders move from smaller/less liquid stocks to large/liquid stocks. Our results suggest that an important explanation for the equity premium in general, and the equity size premium in particular, may be related to time variation in stock market liquidity at business cycle frequencies.

Suggested Citation

  • Naes, Randi & Skjeltorp, Johannes & Odegaard, Bernt Arne, 2008. "Liquidity and the Business Cycle," UiS Working Papers in Economics and Finance 2009/1, University of Stavanger.
  • Handle: RePEc:hhs:stavef:2009_001

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    References listed on IDEAS

    1. Martin D.D. Evans & Richard K. Lyons, 2017. "Order Flow and Exchange Rate Dynamics," World Scientific Book Chapters,in: Studies in Foreign Exchange Economics, chapter 6, pages 247-290 World Scientific Publishing Co. Pte. Ltd..
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    3. Hasbrouck, Joel, 1991. " Measuring the Information Content of Stock Trades," Journal of Finance, American Finance Association, vol. 46(1), pages 179-207, March.
    4. Michael J. Fleming, 2003. "Measuring treasury market liquidity," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 83-108.
    5. Osler, Carol L. & Mende, Alexander & Menkhoff, Lukas, 2011. "Price discovery in currency markets," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1696-1718.
    6. Martin D. D. Evans & Richard K. Lyons, 2017. "Meese-Rogoff Redux: Micro-Based Exchange-Rate Forecasting," World Scientific Book Chapters,in: Studies in Foreign Exchange Economics, chapter 11, pages 457-475 World Scientific Publishing Co. Pte. Ltd..
    7. Sapp, Stephen G., 2002. "Price Leadership in the Spot Foreign Exchange Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(03), pages 425-448, September.
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    9. T. Clifton Green, 2004. "Economic News and the Impact of Trading on Bond Prices," Journal of Finance, American Finance Association, vol. 59(3), pages 1201-1234, June.
    10. Menkveld, Albert J. & Sarkar, Asani & Wel, Michel van der, 2012. "Customer Order Flow, Intermediaries, and Discovery of the Equilibrium Risk-Free Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 47(04), pages 821-849, August.
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    More about this item


    Market Microstructure; Liquidity; Business Cycle;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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