ABSTRACT [article]

I use price dispersion to model liquidity. Buyers may be rationed at the low price. An asset is more liquid if it is used relatively more in low price transactions and the probability that it will buy at the low price is relatively high. In the equilibrium of interest government bonds are more liquid than stocks. Agents with a relatively stable demand are willing to pay a high "liquidity premium" for holding bonds and they specialize in bonds. In equilibrium only a fraction of households (those with relatively unstable demand) hold stocks and the equity premium may be large.

Keywords and Phrases: Liquidity, sequential trade, equity premium puzzle, participation puzzle

JEL Classification Numbers: E42, G12

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