Trading Dynamics in Decentralized Markets with Adverse Selection

We study a dynamic, decentralized market environment with asymmetric information and interdependent values between buyers and sellers, and characterize the complete set of non-stationary equilibria. For a given fraction of low-quality assets, or ``lemons,'' the model describes how prices, the volume of trade, and the composition of assets will evolve over time. Comparing economies in which the initial fraction of lemons varies, the model delivers a stark relationship between the severity of the lemons problem and market liquidity. We use this framework to understand how asymmetric information has contributed to the ``frozen'' credit market at the core of the current financial crisis, and to evaluate the efficacy of one of the policies that was implemented in attempt to restore liquidity.