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Market Liquidity, Asset Prices and Welfare

  • Jennifer Huang
  • Jiang Wang

This paper presents an equilibrium model for the demand and supply of liquidity and its impact on asset prices and welfare. We show that when constant market presence is costly, purely idiosyncratic shocks lead to endogenous demand of liquidity and large price deviations from fundamentals. Moreover, market forces fail to lead to efficient supply of liquidity, which calls for potential policy interventions. However, we demonstrate that different policy tools can yield different efficiency consequences. For example, lowering the cost of supplying liquidity on the spot (e.g., through direct injection of liquidity or relaxation of ex post margin constraints) can decrease welfare while forcing more liquidity supply (e.g., through coordination of market participants) can improve welfare.

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File URL: http://www.nber.org/papers/w14058.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14058.

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Date of creation: Jun 2008
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Publication status: published as Huang, Jennifer & Wang, Jiang, 2010. "Market liquidity, asset prices, and welfare," Journal of Financial Economics, Elsevier, vol. 95(1), pages 107-127, January.
Handle: RePEc:nbr:nberwo:14058
Note: AP
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