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Market Freeze and Recovery: Trading Dynamics under Optimal Intervention by a Market-Maker-of-Last-Resort

Author

Listed:
  • Thorsten V. Koeppl

    (Queen’s University)

  • Jonathan Chiu

    (Bank of Canada)

Abstract

In the context of a search model of asset trading with adverse selection, we demonstrate that trading of a financial asset will cease, when its average quality drops sufficiently. A large player, however, can establish trading again, if he removes a sufficiently large quantity of bad assets which involves assuming losses. Most importantly, we show that such a player does not have to intervene immediately: a mere announcement today of intervening in the future can cause markets to function again. This announcement effect gives rise to a trade-off between the size and the timing of the intervention. The optimal policy balances the (social) costs of transfers against the costs of illiquid markets. If the former are small, it is optimal to ensure that markets function continuously. This is optimally achieved by intervening immediately, but at a minimum scale. When the costs of transfers increase, it is however optimal to delay the intervention and increase its size.

Suggested Citation

  • Thorsten V. Koeppl & Jonathan Chiu, 2010. "Market Freeze and Recovery: Trading Dynamics under Optimal Intervention by a Market-Maker-of-Last-Resort," 2010 Meeting Papers 78, Society for Economic Dynamics.
  • Handle: RePEc:red:sed010:78
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    Cited by:

    1. Derek Stacey, 2011. "Tenure Insecurity, Adverse Selection, and Liquidity in Rural Land Markets," Working Papers 1269, Queen's University, Department of Economics.
    2. Robert Shimer & Veronica Guerrieri, 2012. "Markets with Multidimensional Private Information," 2012 Meeting Papers 1192, Society for Economic Dynamics.
    3. Briana Chang, 2011. "Adverse Selection and Liquidity Distortion in Decentralized Markets," 2011 Meeting Papers 157, Society for Economic Dynamics.
    4. Veronica Guerrieri & Robert Shimer, 2014. "Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality," American Economic Review, American Economic Association, vol. 104(7), pages 1875-1908, July.
    5. Hajime Tomura, 2012. "Asset Illiquidity and Market Shutdowns in Competitive Equilibrium," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(3), pages 283-294, July.
    6. Koralai Kirabaeva, 2010. "Adverse Selection, Liquidity, and Market Breakdown," Staff Working Papers 10-32, Bank of Canada.

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