Liquidity of secondary capital markets: Allocative efficiency and the maturity composition of the capital stock

We investigate the function of liquid financial markets for the allocation of productive capital. We consider an economy where agents endogenously choose among capital production technologies with differing gestation periods. Long-gestation capital investments must be ''rolled-over'' in secondary capital markets. The use of such investment technologies therefore requires the support of liquid financial markets. We investigate how changes in the liquidity of these markets (i.e., in the costs of transacting) affect (a) the choice of capital production technology, (b) per capita income and the per capita capital stock, (c) the level of financial market activity, (d) the real return on savings and (e) welfare in a steady state equilibrium. Improvements in financial market liquidity raise rates of return on savings, and favor the increased use of long gestation capital investments. However, such improvements may or may not lead to higher levels of real activity or steady state welfare. We describe conditions under which various outcomes occur.