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Adverse Selection and Liquidity Distortion in Decentralized Markets

  • Briana Chang
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    Why do some markets remain liquid even when there is a positive gain from trade? In order to understand the real determinants of market liquidity in decentralized markets, we are going to analyze this question in a competitive market setting when both search frictions and adverse selection play roles. In a dynamic environment with heterogeneous sellers and buyers, we investigate the role of market frictions and how adverse selection leads to the distortion of equilibrium market liquidity. The resulting friction therefore prohibits resources from reallocating efficiently. In the application of capital reallocation, we further show that this trading friction can generate significant economic fluctuations.

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    File URL: http://www.kellogg.northwestern.edu/research/math/papers/1513.pdf
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    Paper provided by Northwestern University, Center for Mathematical Studies in Economics and Management Science in its series Discussion Papers with number 1513.

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    Date of creation: 01 Aug 2011
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    Handle: RePEc:nwu:cmsems:1513
    Contact details of provider: Postal: Center for Mathematical Studies in Economics and Management Science, Northwestern University, 580 Jacobs Center, 2001 Sheridan Road, Evanston, IL 60208-2014
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