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

  • Thorsten V. Koeppl

    (Queen’s University)

  • Jonathan Chiu

    (Bank of Canada)

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.

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Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 78.

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Date of creation: 2010
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Handle: RePEc:red:sed010:78
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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