JOURNAL OF FINANCIAL INTERMEDIATION 1, 80-103 (1990) Liquidity without Money: A General Equilibrium Model of Market Microstructure* JAMES PECK Department of Managerial Economics and Decision Sciences, J. L. Kellogg Graduate School of Management, Northwestern University, Evanston, Illinois 60208 We consider a model in which the market period is divided into T rounds of trading, with the arrival of consumers determined exogenously. A monopolistic market maker sets the bid-price and the ask-price in each round, accepting all trades at the stated prices. Optimal prices remain constant when the aggregate supply and demand are known to the market maker, even if supplies and demands within individual rounds are not known. Examples illustrate the endogenous de- termination of inventory holding costs. The viability of a market-maker system is compared to an auction market with and without a “sophisticated” trader. Jour- nal of Economic Literature Classification Numbers: 021,022,026. B 1~0Academic Press, Inc. 1. INTRODUCTION With complete markets, a competitive equilibrium results in a Pareto optimal allocation, and the liquidity of markets is an irrelevant concept. This paper begins with the view that markets are incomplete and provides a general equilibrium analysis of market liquidity and the market making function. Liquidity is provided in a model without money. The paper * This paper has benefitted from the suggestions of two editors and a referee of this journal. I also thank Larry Ausubel, Raymond Deneckere, Larry Glosten, Kathleen Ha- gerty, Karl Shell, and Ross Starr for helpful discussions. Remaining errors and omissions are my own. Financial support was provided by the Banking Research Center, at the J. L. Kellogg Graduate School of Management, Northwestern University. This paper is a com- plete revision of BRC Working Paper 162. 80 1042-9573190 $3.00 Copyright 0 1990 by Academic Press, Inc. All rights of reproduction in any form reserved.