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Market and Funding Liquidity: Drivers of Liquidity and Real Effects

20th National Competition for Economic Research Grants (2021)

Economic analysis

Senior Researcher : Jesper Rüdiger

Research Centre or Institution : Universidad Carlos III de Madrid.

Abstract

Liquidity is at the heart of the economic system and is a subject that has taken the forefront in financial market research. Many markets, such as government bonds, which were previously considered highly liquid have recently experienced trading disruptions, which has also added to the importance of liquidity in the public debate. Therefore, understanding liquidity provision and how it interacts with the different parts of the economy is an issue of the greatest importance.

The term liquidity can refer both to market liquidity, which measures the cost of trading, and funding liquidity, which measures the cost of obtaining funding. The two types of liquidity are closely linked: market liquidity is created through trading, which requires funding liquidity; conversely, an important source of funding liquidity is the conversion of long-term assets into liquid means, and this depends on market liquidity.

Our project studies the drivers as well as the real effects of changes in market and funding liquidity and is divided into three sub-projects. Two sub-projects investigate market liquidity
in, respectively, the market for Treasury bills and the stock market. Market liquidity in these two asset groups is closely linked to funding liquidity: Treasury bills are a key component of the overall credit market which determines funding liquidity for firms and individuals and stock market liquidity is strongly linked to funding liquidity for investors and intermediaries.  The third sub-project investigates the real effects of funding liquidity shocks: liquidity droughts are shown to propagate through the economy via credit shocks and have substantial real effects on firms' performance, labor market reallocation, investment and firm exit.

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