| Abstract: |
This paper presents an equilibrium model for the demand and supply of
liquidity and its impact on asset prices and welfare. We show that when
constant market presence is costly, purely idiosyncratic shocks lead to
endogenous demand of liquidity and large price deviations from fundamentals.
Moreover, market forces fail to lead to efficient supply of liquidity, which
calls for potential policy interventions. However, we demonstrate that
different policy tools can yield different efficiency consequences. For
example, lowering the cost of supplying liquidity on the spot (e.g., through
direct injection of liquidity or relaxation of ex post margin constraints) can
decrease welfare while forcing more liquidity supply (e.g., through
coordination of market participants) can improve welfare. |