Market Liquidity and Liquid Wealth

Are securities markets more liquid when the economy is more liquid? If so, why? One possibility is that market depth depends on credit constrained intermediaries. This paper offers another explanation, which does not involve frictions or market segmentation. Measuring market illiquidity by the slope of the representative agent’s demand curve for a risky asset, I show that this slope is steeper when money-like investments (or liquid wealth) represent less of an economy’s assets. That is because an exchange of risky shares for money in such a state induces greater intertemporal substitution than it does when there are more liquid balances. Agents are not indifferent to this substitution, and so prices respond more to trade. Thus market illiquidity fluctuates naturally with the level of real liquidity. This observation has important implication for understanding the causes of liquidity risk and market fragility.