A theory of procyclical market liquidity

Günter Strobl

Journal of Economic Dynamics and Control, 2022, vol. 138, issue C

Abstract: This paper presents a theory of liquidity cycles based on endogenous fluctuations in economic activity and the availability of informed capital. Risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets depends on the endogenous information structure in the market. Liquidity provision is modeled as a repeated game with imperfect public monitoring. We construct a trigger-strategy equilibrium along the lines of Green and Porter (1984) that is characterized by stochastic fluctuations in liquidity. Liquidity is procyclical in our economy. Periods of economic growth are associated with more liquid asset markets.

Keywords: Market liquidity; Adverse selection; Business cycle; Repeated game (search for similar items in EconPapers)
JEL-codes: D82 D83 E22 E32 G14 (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:138:y:2022:i:c:s0165188922000318

DOI: 10.1016/j.jedc.2022.104326

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