Abstract
This paper presents a theory of liquidity cycles based on endogenous uctuations in economic activity and the availability of informed capital. Risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets depends on the endogenous information structure in the market. Liquidity provision is modeled as a repeated game with imperfect public monitoring. We construct a triggerstrategy equilibrium along the lines of Green and Porter (1984) that is characterized by stochastic uctuations in liquidity. Liquidity is procyclical in our economy. Periods of economic growth are associated with more liquid asset markets. However, unlike other explanations in the literature, our results do not rely on exogenous shocks to the economy. Rather, uctuations in liquidity arise endogenously from the need to create incentives for
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