During the recent financial crisis we have learned that the functioning of financial markets depends crucially on the availability of liquidity. This paper develops a model that shows how market liquidity is influenced by asymmetric information and a restricted market access. In equilibrium liquidity may be too high or too low, moreover the market may fail due to an adverse selection problem. I analyze how the market outcome can be improved by appropriate ex-ante and ex-post policy interventions. Furthermore I contribute to the discussion on the initial crisis response of the U.S. Federal Reserve in 2007 and 2008 by analyzing the effectiveness of an asset purchasing program that is financed by a change in the central bank’s balance sheet decomposition.
Interestingly, I find that a pure change in the portfolio decomposition (i.e. the central bank only reallocates cash in the economy, instead of doing quantitative easing) can only be effective if the central bank, first, crowds out all the private liquidity provision to the asset market, second, is willing to incur a loss and, third, has the ability to borrow against future tax revenues. Moreover, I find that such an intervention is preferable to a guarantee scheme by the government if taxation causes a distortion.
My paper develops a model of liquidity provision where agents face idiosyncratic liquidity risk that emerges through a “cost shock”. Agents can face the liquidity need by using the cash they have in hand, by selling risky long-term assets and by borrowing against the safe return of an investment project which itself is tradable and subject to the cost shock. Hence idiosyncratic liquidity risk is shared in two distinct spot markets. One of them is a market for trade in risky long-term assets which is prone to an asymmetric information problem and the other one is a market for borrowing against the safe return of an internal investment project which, by itself, cannot be sold to other agents.
In contrast to the lemons asset market, the latter market does not have an informational friction, however agents do only have limited access to it. The notion of “liquidity” used in this paper refers to the cost of converting the expected future income into cash. This cost of transferring future income is higher, the stronger the adverse selection problem in the lemons asset market and the less cash is available in the economy.
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A Model of Liquidity Provision with Adverse Selection
