Thursday, January 31, 2013

When restricting access to financial markets is good

In standard economic theory, any friction that inhibits the clearing of markets or efficient allocations is viewed as bad, and so it should. But there may be some situations where adding frictions leads to better outcomes. One example is the Tobin tax of financial transactions which is thought to prevent excessive speculation and volatility.

Aleksander Berentsen, Samuel Huber and Alessandro Marchesiani have come up with another potentially useful friction. Imagine a world where economic agents face individual and aggregate shocks to liquidity, and there are liquid (money) and illiquid asset markets. Of course, they will want to use these assets to insure themselves against these fluctuations. One way is to accumulate liquid assets yourself. Another is to acquire them from others when needed. But because the latter option is easily available, there is not enough aggregate liquidity as its price is too low: people do not factor in the positive externality on markets of getting more liquidity. The authors argue that this effect can be so strong that it is worthwhile curtailing financial markets so that agent accumulate more liquidity for themselves (and others).

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