Paper #1583

Title:

Liquidity sentiments

Authors:

Vladimir Asriyan, William Fuchs and Brett Green

Date:

October 2017 (Revised: June 2018)

Abstract:

We develop a rational theory of liquidity sentiments in which the market outcome in any given period depends on agents' expectations about market conditions in future periods. Our theory is based on the interaction between adverse selection and resale considerations giving rise to an intertemporal coordination problem that yields multiple self-fulfilling equilibria. We construct "sentiment" equilibria in which sunspots generate fl uctuations in prices, volume, and welfare, all of which are positively correlated. The intertemporal nature of the coordination problem disciplines the set of possible sentiment dynamics. In particular, sentiments must be sufficiently persistent and transitions must be stochastic. We consider an extension with production in which asset quality is endogenously determined and provide conditions under which sentiments are a necessary feature of any equilibrium. A testable implication of the model is that assets produced in good times are of lower average quality than those produced in bad times. We discuss the predictions of our theory within the context of several applications.

Keywords:

Sentiment, adverse selection, liquidity, capital reallocation, bubbles

JEL codes:

D82, E32, G12

Area of Research:

Macroeconomics and International Economics

Comment:

Forthcoming in American Economic Review.

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