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Market Liquidity, Asset Prices and Welfare

Jennifer Huang and Jiang Wang

No 14058, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper presents an equilibrium model for the demand and supply of liquidity and its impact on asset prices and welfare. We show that when constant market presence is costly, purely idiosyncratic shocks lead to endogenous demand of liquidity and large price deviations from fundamentals. Moreover, market forces fail to lead to efficient supply of liquidity, which calls for potential policy interventions. However, we demonstrate that different policy tools can yield different efficiency consequences. For example, lowering the cost of supplying liquidity on the spot (e.g., through direct injection of liquidity or relaxation of ex post margin constraints) can decrease welfare while forcing more liquidity supply (e.g., through coordination of market participants) can improve welfare.

JEL-codes: E44 E58 G12 G18 (search for similar items in EconPapers)
Date: 2008-06
New Economics Papers: this item is included in nep-bec, nep-mac and nep-mst
Note: AP
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Published as Huang, Jennifer & Wang, Jiang, 2010. "Market liquidity, asset prices, and welfare," Journal of Financial Economics, Elsevier, vol. 95(1), pages 107-127, January.

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