Leaning Against the Wind

During financial disruptions, market makers provide liquidity by absorbing external selling pressure. They buy when the pressure is large, accumulate inventories, and sell when the pressure alleviates. This paper studies optimal dynamic liquidity provision in a theoretical market setting with large and temporary selling pressure and order-execution delays. I show that competitive market makers offer the socially optimal amount of liquidity, provided they have access to sufficient capital. If raising capital is costly, this suggests a policy role for lenient central bank lending during financial disruptions.     

The Elusive Gains from International Financial Integration

Standard theoretical arguments tell us that countries with relatively little capital benefit from financial integration as foreign capital flows in and speeds up the process of convergence. We show in a calibrated neoclassical model that conventionally measured welfare gains from this type of convergence appear relatively limited for the typical emerging market country. The welfare gain from switching from financial autarky to perfect capital mobility is roughly equivalent to a 1% permanent increase in domestic consumption for the typical non-OECD country. This is negligible relative to the welfare gain from a take-off in domestic productivity of the magnitude observed in some of these countries.