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Trading Dynamics in Decentralized Markets with Adverse Selection

  • Ben Lester

    (University of Western Ontario)

  • Braz Camargo

    (Sao Paulo School of Economics - FGV)

We study a dynamic, decentralized market environment with asymmetric information and interdependent values between buyers and sellers, and characterize the complete set of non-stationary equilibria. For a given fraction of low-quality assets, or ``lemons,'' the model describes how prices, the volume of trade, and the composition of assets will evolve over time. Comparing economies in which the initial fraction of lemons varies, the model delivers a stark relationship between the severity of the lemons problem and market liquidity. We use this framework to understand how asymmetric information has contributed to the ``frozen'' credit market at the core of the current financial crisis, and to evaluate the efficacy of one of the policies that was implemented in attempt to restore liquidity.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1300.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1300
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