NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality

Veronica Guerrieri, Robert Shimer

NBER Working Paper No. 17876
Issued in March 2012
NBER Program(s):   AP   EFG

We develop a dynamic equilibrium model of asset markets affected by adverse selection. There exists a unique equilibrium where better assets trade at higher prices but in less liquid markets. Sellers of high-quality assets can separate because they are more willing to accept a lower trading probability. As a result, the emergence of adverse selection generates a drop in liquidity. It may also lead to a decline in the price-dividend ratio—a fire sale—and a flight to quality. Subsidies to purchasing assets may be Pareto improving and can reverse the fire sale and flight to quality.

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Document Object Identifier (DOI): 10.3386/w17876

“Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality,” with Robert Shimer, AER, forthcoming

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