Can there be too much trading in financial markets? We construct a dynamic general equilibrium model, where agents face idiosyncratic liquidity shocks. A financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The optimal policy is to restrict access to this market because portfolio choices exhibit a pecuniary externality: Agents do not take into account that by holding more of the liquid asset, they not only acquire additional insurance against these liquidity shocks, but also marginally increase the value of the liquid asset, which improves insurance for other market participants.

In the 1990s, the empirical relationship between money demand and interest rates began to fall apart. We analyze to what extent financial innovations can explain this breakdown. For this purpose, we construct a microfounded monetary model with a money market that provides insurance against liquidity shocks by offering short-term loans and by paying interest on money market deposits. We calibrate the model to U.S. data and find that the introduction of the sweep technology at the beginning of the 1990s, which improved access to money markets, can explain the behavior of money demand very well. Furthermore, by allowing a more efficient allocation of money, the welfare cost of inflation decreased substantially.JEL codes: D9, E4, E5

Can there be too much trading in financial markets? We construct a dynamic general equilibrium model, where agents face idiosyncratic liquidity shocks. A financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The optimal policy is to restrict access to this market because portfolio choices exhibit a pecuniary externality: Agents do not take into account that by holding more of the liquid asset, they not only acquire additional insurance against these liquidity shocks, but also marginally increase the value of the liquid asset, which improves insurance for other market participants. .2 Our basic framework is the divisible money model developed in Lagos and Wright (2005). The main departure from this framework is that we add government bonds and a secondary bond market, where agents can trade bonds for money after experiencing an i.i.d. liquidity shock. 3 We call an asset that can be exchanged for consumption goods liquid and one that cannot be exchanged illiquid. In our model, the liquid asset is fiat money and the illiquid asset is a one-period government bond. The fact that government bonds cannot be used as a medium of exchange to acquire consumption goods is the consequence of certain assumptions that we impose on our environment as explained in the main discourse of this article. 735 C (2014) by the

We provide a novel justi…cation for a …nancial transaction tax for economies, where agents face stochastic consumption opportunities. A …nancial transaction tax makes it more costly for agents to readjust their portfolios of liquid and illiquid assets in response to these liquidity shocks, which increases the demand for-and the price of liquid assets. The higher price improves liquidity insurance and welfare for other market participants. We calibrate the model to U.S. data and …nd that the optimal …nancial transaction tax is 1.6 percent and that it reduces the volume of …nancial trading by 17 percent.

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