Disagreement and Liquidity

Abstract

Disagreement can affect the relation between private information and liquidity. In a model in which trading is entirely generated by disagreement stemming from overconfident interpretation of private signals, private information increases trading and enhances liquidity. In a more general version of the model that incorporates both disagreement and liquidity trading, the relation between private information and liquidity is non-monotonic. Private information at first decreases liquidity and then enhances it, potentially explaining why private information seems to destroy liquidity in money markets but not in markets that are more informationally sensitive to start with.

Keywords: disagreement, liquidity, private information, overconfidence

JEL Classification: D82, G12, G14, G41