Free-Riding on Liquidity
University of Zurich Economics Working Paper No. 32
30 Pages Posted: 9 Nov 2011 Last revised: 22 Dec 2012
Date Written: September 30, 2011
Abstract
Do financial market participants free-ride on liquidity? To address this question, we construct a dynamic general equilibrium model where agents face idiosyncratic preference and technology shocks. A secondary financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The opportunity to do so reduces the demand for the liquid asset and, hence, its value. The optimal policy response is to restrict (but not eliminate) access to the secondary financial market. The reason for this result is that the portfolio choice exhibits a pecuniary externality: An agent does not take into account that by holding more of the liquid asset, he not only acquires additional insurance but also marginally increases the value of the liquid asset which improves insurance to other market participants.
Keywords: Monetary Policy, liquidity, financial markets
JEL Classification: E52, E58, E59
Suggested Citation: Suggested Citation
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