Liquid Capital and Market Liquidity

It is widely believed that the resilience of the stock market and its ability to accurately set prices are affected by credit conditions in the economy. A scarcity of deployable capital may cause market-makers to become financially constrained, leading to a breakdown in intermediation. This paper describes another channel by which the supply of available capital affects secondary market liquidity. When agents hold more wealth in technologically liquid investments, a marginal adjustment to portfolio holdings alters discount rates less, causing a smaller price impact. The stock of liquid wealth also buffers income shocks, leading to lower risk premia and lower volatility when savings are high. The theory thus implies that, even without intermediaries or frictions, the degree of liquid capital may be a crucial determinant of asset market conditions.