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What happens when liquidity increases in credit markets and more funds are channeled from borrowers to lenders? We examine this question in a general equilibrium search model where borrowers (firms) and lenders (households) are either brought together via random matching or assortive financial matchmaking and where the composition of heterogeneous borrowers adjusts to satisfy equilibrium entry conditions. We find that enhanced liquidity causes entry by all borrowers and tends to benefit low quality borrowers disproportionately. However, liquid credit markets may or may not be associated with higher social output. The result is determined by whether the effect of higher market participation outweighs that of lower average quality. The net effect depends crucially on the source of the liquidity shock (credit search efficacy, productivity, or entry barriers).

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