Liquidity When It Matters Most: QE and Tobin's Q

Abstract:     
How and why do financial conditions matter for real outcomes? The workhorse model of money and liquidity of Kiyotaki and Moore (2008) shows how - with full employment maintained by flexible prices - shifting credit constraints can affect investment and future aggregate supply. We show that, when the flex-price assumption is dropped, an adverse but temporary liquidity shock can rapidly lead to Keynesian-style demand failure. Optimistic expectations may speed recovery, but simulation results suggest that prompt liquidity infusion by the central bank - i.e. Quantitative Easing - is needed to check prolonged recession.

Number of Pages in PDF File: 40

Keywords: Credit Constraints, Liquidity Shocks, Temporary Equilibrium

JEL Classification: B22, E12, E20, E30, E44

working papers series