Free-riding on liquidity

Aleksander Berentsen, Samuel Huber () and Alessandro Marchesiani ()

No 32, ECON - Working Papers from Department of Economics - University of Zurich

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 (search for similar items in EconPapers)
JEL-codes: E52 E58 E59 (search for similar items in EconPapers)
Date: 2011-09
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:zur:econwp:032

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