Liquid Assets, Illiquid Assets and Sunspots

Abstract

In this paper, I first show that liquid assets make risk-averse agents better off by eliminating multiple equilibria and thus eliminating speculation based on nonfundamentals. I then show that illiquid assets make risk-averse agents worse off by enlarging the set of economies (or agent preferences) that give rise to sunspot equilibria. In addition, my results show that with illiquid assets, nonfundamental volatility results as follows: In order to smooth consumption, some agents endogenously create private claims backed by these illiquid capital assets. These claims have multiple price equilibria, and their fluctuating prices cause the prices of the illiquid capital assets to fluctuate as well. The excess volatility makes all risk-averse agents worse off (in a Pareto sense). My model also shows equilibrium idiosyncratic risk bearing in illiquid asset markets by certain segments of the population which should be of concern to regulators and policy makers. For example, in real estate markets, there is a role for government intervention and for government-supplied liquidity and for its active management.