On Market Liquidity and Liquid Balances

31 Pages Posted: 25 Jan 2006

See all articles by Timothy C. Johnson

Timothy C. Johnson

London Business School; University of Illinois

Date Written: November 2005

Abstract

Are securities markets more liquid when the economy is more liquid? If so, why? One possibility is that market depth depends on credit constrained intermediaries. This paper offers another explanation, which does not involve frictions or market segmentation. Measuring market illiquidity by the slope of the representative agent's demand curve for a risky asset, I show that this slope is steeper when money-like investments (or liquid balance) represent less of an economy's assets. That is because an exchange of shares for money in such a state induces greater intertemporal substitution than it does when there are more liquid balances. Thus securities' illiquidity fluctuates naturally with the level of real liquidity. This observation has important implication for understanding the causes of market fragility.

Keywords: liquidity, liquidity risk, savings, asset pricing

JEL Classification: D91, E21, E44, E52, G12

Suggested Citation

Johnson, Tim and Johnson, Tim, On Market Liquidity and Liquid Balances (November 2005). Available at SSRN: https://ssrn.com/abstract=878084 or http://dx.doi.org/10.2139/ssrn.878084

Tim Johnson (Contact Author)

University of Illinois ( email )

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