Dynamic Liquidity in Endowment Economies

This paper analyzes systematic variations in market liquidity that arise in standard representative-agent endowment economies. I introduce a natural definition of liquidity that applies whether or not the model supports actual trade in securities. This fundamental endogenous liquidity is driven by the underlying risk dynamics of the economy, and hence does not depend on whatever drives demand for liquidity. I argue that time-varying aggregate liquidity – and hence liquidity risk – can be at least partially understood from this perspective. I quantify the effects that characterize some tractable example economies, and show that both the degree of liquidity and its variation with the level, volatility, and expected return of the market can be similar to those observed empirically.