Endogenous Liquidity Cycles

May 2012.

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. However, unlike other explanations in the literature, our results do not rely on exogenous shocks to the economy. Rather, fluctuations in liquidity arise endogenously from the need to create incentives for investors to engage in costly information production.

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