This paper represents an equilibrium model for the demand and supply of liquidity and its impact on asset prices and welfare. We show that, when constant market presence is costly, purely idiosyncratic shocks lead to endogenous demand of liquidity and large price deviations from fundamentals. Moreover, market forces fail to lead to efficient supply of liquidity, which calls for potential policy interventions. However, we demonstrate that different policy tools can yield different efficiency consequences. For example, lowering the cost of supplying liquidity on the spot (e.g., through direct injection of liquidity or relaxation of ex post margin constraints) can decrease welfare while forcing more liquidity supply (e.g., through coordination of market participants) can improve welfare.

We empirically investigate the impact of government debt on corporate financing decisions in an international setting. We show a negative relation between government debt and corporate leverage using data on 40 countries between 1990–2014. This negative relation is stronger for government debt that is financed domestically, for firms that are larger and more profitable, and in countries with more developed equity markets. To address potential endogeneity concerns, we use an instrumental variable approach based on military spending and a quasi-natural experiment based on the introduction of the Euro currency. Our findings suggest that government debt crowds out corporate debt.