The Role of Trading Frictions in Financial Markets

We develop a dynamic general equilibrium model to analyze the role of trading frictions in over-the-counter financial markets. In our model, agents face idiosyncratic preference shocks and a financial market allows them to rebalance their portfolio composed of liquid and illiquid assets in response to these shocks. We disentangle the effects of search and bargaining on welfare and study each one of them. We show that bargaining is welfare-improving for any inflation rate above the Friedman rule, while search frictions are not. This is because search frictions do not only affect the demand for the respective assets, but also their allocation