Toxic Assets and Market Freezes

Working Paper Number: 
WP 20-01

We study economies where some assets are toxic - i.e., they have negative returns - but still have positive prices because they provide liquidity as payment instruments or as collateral. Even without changes in fundamentals markets can, as a self-fulfilling prophecy, freeze and thaw recurrently: toxic assets stop trading for a spell, then restart. We show markets without toxic assets might have hot and cold spells, where prices and quantities fluctuate, but cannot freeze and thaw (at least without nonconvexities.). Freezes can occur when there are toxic assets plus fiat currency, and whether these assets trade for goods or trade for money.

JEL Codes: 
E30, E44, E52, G14, D53, D83

Guido Menzio

Randall Wright

Yu Zhu