Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

Abstract

We study trading dynamics in an asset market where the quality of assets is private information and finding a counterparty takes time. When trading ceases in equilibrium as a response to an adverse shock to asset quality, a government can resurrect trading by buying up lemons which involves a financial loss. The optimal policy is centred around an announcement effect where trading starts already before the intervention for two reasons. First, delaying the intervention allows selling pressure to build up thereby improving the average quality of assets for sale. Secondly, intervening at a higher price increases the return from buying an asset of unknown quality. It is optimal to intervene immediately at the lowest price when the market is sufficiently important. For less important markets, when the shock to quality and search frictions are small, it is optimal to rely on the announcement effect. Here delaying the intervention and fostering the effect by intervening at the highest price tend to be complements.

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