Inefficient liquidity provision
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We prove that in competitive market economies with no insurance for idiosyncratic risks, agents will always overinvest in illiquid long-term assets and underinvest in short-term liquid assets. We take as our setting the seminal model of Diamond and Dybvig (J Polit Econ 91(3):401–419, 1983), who first posed the question in a tractable model. We reach such a simple conclusion under mild conditions because we stick to the basic competitive market framework, avoiding the banks and intermediaries that Diamond and Dybvig (1983) and others introduced.
KeywordsLiquidity Constrained inefficiency Diamond–Dybvig models Fire sales
JEL ClassificationE44 D5 E43 E6 G18
This paper grew from discussions in the Reading Group on Financial Markets and Macroeconomic Fragility at Yale University. We thank all participants. Thank you especially to Alexis Akira Toda for providing us with very useful and detailed comments.
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