Contagious Illiquidity I: Contagion through Time

Research output: Working paperDiscussion paper

Abstract / Description of output

This paper is an investigation into the dynamics of asset markets with adverse
selection à la Akerlof (1970). The particular question asked is: can market failure at some later date precipitate market failure at an earlier date? The answer is yes: there can be “contagious illiquidity” from the future back to the present.

The mechanism works as follows. If the market is expected to break down in the
future, then agents holding assets they know to be lemons (assets with low eturns) will be forced to hold them for longer – they cannot quickly resell them. As a result, the effective difference in payoff between a lemon and a good asset is greater. But it is known from the static Akerlof model that the greater the payoff differential between lemons and non-lemons, the more likely is the market to break down. Hence market failure in the future is more likely to lead to market failure today. Conversely, if the market is not anticipated to break down in the future, assets can be readily sold and hence an agent discovering that his or her asset is a lemon can quickly jettison it. In effect, there is little difference in payoff between a lemon and a good asset. The logic of the static Akerlof model then runs the other way: the small payoff differential is unlikely to lead to market breakdown today. The conclusion of the paper is that the nature of today’s market – liquid or illiquid –hinges critically on the nature of tomorrow’s market, which in turn depends on the next day’s, and so on. The tail wags the dog.
Original languageEnglish
PublisherEdinburgh School of Economics Discussion Paper Series
Number of pages17
Publication statusPublished - Oct 2013

Publication series

NameESE Discussion Papers


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