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The role of trading frictions in financial markets

Author

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  • Samuel Huber
  • Jaehong Kim

Abstract

We develop a dynamic general equilibrium model to analyze the role of trading frictions in over-the-counter financial markets. In our model, agents face idiosyncratic preference shocks and a financial market allows them to rebalance their portfolio composed of liquid and illiquid assets in response to these shocks. We disentangle the effects of search and bargaining on welfare and study each one of them. We show that bargaining is welfare-improving for any inflation rate above the Friedman rule, while search frictions are not. This is because search frictions do not only affect the demand for the respective assets, but also their allocation.

Suggested Citation

  • Samuel Huber & Jaehong Kim, 2015. "The role of trading frictions in financial markets," ECON - Working Papers 211, Department of Economics - University of Zurich, revised Jul 2017.
  • Handle: RePEc:zur:econwp:211
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    File URL: http://www.econ.uzh.ch/static/wp/econwp211.pdf
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    References listed on IDEAS

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    1. Berentsen, Aleksander & Huber, Samuel & Marchesiani, Alessandro, 2016. "The societal benefit of a financial transaction tax," European Economic Review, Elsevier, vol. 89(C), pages 303-323.
    2. Athanasios Geromichalos & Lucas Herrenbrueck, 2016. "Monetary Policy, Asset Prices, and Liquidity in Over‐the‐Counter Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(1), pages 35-79, February.
    3. Ingo Fender & Ulf Lewrick, 2015. "Shifting tides - market liquidity and market-making in fixed income instruments," BIS Quarterly Review, Bank for International Settlements, March.
    4. Ricardo Lagos, 2011. "Asset Prices, Liquidity, and Monetary Policy in an Exchange Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 521-552, October.
    5. David Andolfatto, 2011. "A note on the societal benefits of illiquid bonds," Canadian Journal of Economics, Canadian Economics Association, vol. 44(1), pages 133-147, February.
    6. Stephens, Eric & Thompson, James R., 2014. "CDS as insurance: Leaky lifeboats in stormy seas," Journal of Financial Intermediation, Elsevier, vol. 23(3), pages 279-299.
    7. Aleksander Berentsen & Guido Menzio & Randall Wright, 2011. "Inflation and Unemployment in the Long Run," American Economic Review, American Economic Association, vol. 101(1), pages 371-398, February.
    8. Huber, Samuel & Kim, Jaehong, 2017. "On the optimal quantity of liquid bonds," Journal of Economic Dynamics and Control, Elsevier, vol. 79(C), pages 184-200.
    9. Berentsen, Aleksander & Camera, Gabriele & Waller, Christopher, 2007. "Money, credit and banking," Journal of Economic Theory, Elsevier, vol. 135(1), pages 171-195, July.
    10. Benjamin Lester & Andrew Postlewaite & Randall Wright, 2012. "Information, Liquidity, Asset Prices, and Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 79(3), pages 1209-1238.
    11. Jacquet, Nicolas L. & Tan, Serene, 2012. "Money and asset prices with uninsurable risks," Journal of Monetary Economics, Elsevier, vol. 59(8), pages 784-797.
    12. Aleksander Berentsen & Samuel Huber & Alessandro Marchesiani, 2014. "Degreasing The Wheels Of Finance," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 55, pages 735-763, August.
    13. Chun, Youngsub & Thomson, William, 1988. "Monotonicity properties of bargaining solutions when applied to economics," Mathematical Social Sciences, Elsevier, vol. 15(1), pages 11-27, February.
    14. James R. Thompson, 2010. "Counterparty Risk in Financial Contracts: Should the Insured Worry About the Insurer?," The Quarterly Journal of Economics, Oxford University Press, vol. 125(3), pages 1195-1252.
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    1. repec:eee:dyncon:v:79:y:2017:i:c:p:184-200 is not listed on IDEAS
    2. Huber, Samuel & Kim, Jaehong, 2017. "On the optimal quantity of liquid bonds," Journal of Economic Dynamics and Control, Elsevier, vol. 79(C), pages 184-200.
    3. Constantin ANGHELACHE & Emilia STANCIU & Marius POPOVIC & Alexandru URSACHE, 2016. "Aspects regarding macro-prudential Instruments ensuring financial stability," Romanian Statistical Review Supplement, Romanian Statistical Review, vol. 64(5), pages 83-85, May.

    More about this item

    Keywords

    Monetary theory; over-the-counter markets; financial regulation; corporate bonds; liquidity;

    JEL classification:

    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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