Endogenous Liquidity Cycles

Abstract

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 triggerstrategy equilibrium along the lines of Rather, fluctuations in liquidity arise endogenously from the need to create incentives for investors to engage in costly information production