Adverse Selection and Liquidity Distortion in Decentralized Markets

Briana Chang

Discussion Papers from Northwestern University, Center for Mathematical Studies in Economics and Management Science

Abstract: Why do some markets remain liquid even when there is a positive gain from trade? In order to understand the real determinants of market liquidity in decentralized markets, we are going to analyze this question in a competitive market setting when both search frictions and adverse selection play roles. In a dynamic environment with heterogeneous sellers and buyers, we investigate the role of market frictions and how adverse selection leads to the distortion of equilibrium market liquidity. The resulting friction therefore prohibits resources from reallocating efficiently. In the application of capital reallocation, we further show that this trading friction can generate significant economic fluctuations.

Keywords: Liquidity; Search frictions, Adverse selection; Uncertainty; Capital Reallocation JEL Classification Numbers: D82, G1 (search for similar items in EconPapers)
Date: 2011-08-01
New Economics Papers: this item is included in nep-cta and nep-dge
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Citations: View citations in EconPapers (12)

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