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Liquidity and Congestion

  • Gara Minguez Afonso

    (LSE / Princeton University)

Registered author(s):

    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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    File URL: https://www.economicdynamics.org/meetpapers/2008/paper_926.pdf
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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
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    Handle: RePEc:red:sed008:926
    Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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    Web page: http://www.EconomicDynamics.org/society.htm
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    1. 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.
    2. Ricardo Lagos & Guillaume Rocheteau, 2009. "Liquidity in Asset Markets With Search Frictions," Econometrica, Econometric Society, vol. 77(2), pages 403-426, 03.
    3. Acharya, Viral V & Pedersen, Lasse Heje, 2004. "Asset Pricing with Liquidity Risk," CEPR Discussion Papers 4718, C.E.P.R. Discussion Papers.
    4. Dimitri Vayanos & Pierre-Olivier Weill, 2007. "A search-based theory of the on-the-run phenomenon," LSE Research Online Documents on Economics 24474, London School of Economics and Political Science, LSE Library.
    5. 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.
    6. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society.
    7. Guillaume Plantin, 2003. "Self-fulfilling liquidity and the coordination premium," LSE Research Online Documents on Economics 24756, London School of Economics and Political Science, LSE Library.
    8. Pagano, Marco, 1986. "Trading Volume and Asset Liquidity," CEPR Discussion Papers 142, C.E.P.R. Discussion Papers.
    9. P. Diamond, 1980. "Aggregate Demand Management in Search Equilibrium," Working papers 268, Massachusetts Institute of Technology (MIT), Department of Economics.
    10. Denis Gromb & Dimitri Vayanos, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," LSE Research Online Documents on Economics 448, London School of Economics and Political Science, LSE Library.
    11. 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.
    12. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    13. Milgrom, Paul & Roberts, John, 1990. "Rationalizability, Learning, and Equilibrium in Games with Strategic Complementarities," Econometrica, Econometric Society, vol. 58(6), pages 1255-77, November.
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