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Liquidity and Congestion

  • Gara Minguez Afonso

    (LSE / Princeton University)

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    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 (thick market externality effect). But secondly, 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 (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 deteriorate liquidity and reduce welfare.

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    Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 926.

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    Date of creation: 2008
    Date of revision:
    Handle: RePEc:red:sed008:926
    Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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    1. Pierre-Olivier Weill & Dimitri Vayanos, 2005. "A Search-Based Theory of the On-the-Run Phenomenon," 2005 Meeting Papers 701, Society for Economic Dynamics.
    2. 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.
    3. Dimitri Vayanos & Tan Wang, 2004. "Search and endogenous concentration of liquidity in asset markets," LSE Research Online Documents on Economics 455, London School of Economics and Political Science, LSE Library.
    4. Acharya, Viral V. & Pedersen, Lasse Heje, 2005. "Asset pricing with liquidity risk," Journal of Financial Economics, Elsevier, vol. 77(2), pages 375-410, August.
    5. Ricardo Lagos & Guillaume Rocheteau, 2007. "Liquidity in asset markets with search frictions," Working Paper 0706, Federal Reserve Bank of Cleveland.
    6. Weill, Pierre-Olivier, 2008. "Liquidity premia in dynamic bargaining markets," Journal of Economic Theory, Elsevier, vol. 140(1), pages 66-96, May.
    7. Milgrom, Paul & Roberts, John, 1990. "Rationalizability, Learning, and Equilibrium in Games with Strategic Complementarities," Econometrica, Econometric Society, vol. 58(6), pages 1255-77, November.
    8. Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.
    9. 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.
    10. Dimitri Vayanos, 1998. "Transaction costs and asset prices : a dynamic equilibrium model," LSE Research Online Documents on Economics 451, London School of Economics and Political Science, LSE Library.
    11. Guillaume Plantin, 2004. "Self-Fulfilling Liquidity and the Coordination Premium," GSIA Working Papers 2005-E3, Carnegie Mellon University, Tepper School of Business.
    12. Pagano, Marco, 1986. "Trading Volume and Asset Liquidity," CEPR Discussion Papers 142, C.E.P.R. Discussion Papers.
    13. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
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