Frictional asset reallocation under adverse selection

Abstract

This paper studies asset reallocation in over-the-counter markets subject to search, bargaining, and information frictions, and discusses their implications for optimal monetary policy. The results show that inefficiencies arise from trade under private information, resulting in reduced trading volume and consumption. Conditional on search frictions in the over-the-counter market, information frictions can be both welfare-decreasing and welfare-increasing, addressing the pecuniary externality arising from the portfolio choice of liquid and illiquid assets. Optimality is guaranteed under the Friedman rule. Away from the Friedman rule, efficiency can be restored through open market operations, exchanging information-sensitive assets for risk-free bonds, as conducted by the Federal Reserve in response to the global financial crisis.