Endogenously Procyclical Liquidity, Capital Reallocation, and q

67 Pages Posted: 17 Nov 2014 Last revised: 25 Feb 2022

See all articles by Melanie Cao

Melanie Cao

York University - Schulich School of Business

Shouyong Shi

Pennsylvania State University

Date Written: July 1, 2017

Abstract

Capital reallocation is procyclical and an economic boom has a cleansing effect by shifting the distribution of firms from low quality to high quality. To explain these facts, we model an economy with search frictions in the market for used capital and shocks to aggregate productivity. The key feature of the model is that market liquidity is procyclical endogenously, which is generated by the entry of buyers into the market. We characterize the stochastic equilibrium analytically to prove that the amount and the price of reallocated capital increase in aggregate productivity. Procyclical reallocation generates the cleansing effect of a boom. We calibrate the model to simulate the dynamic response of the equilibrium to the aggregate shock. Moreover, we construct proxies in the data for the unemployment rate of capital and the time on the market, and show that the two variables have a strong positive relationship in both the model and the data.

Keywords: Endogenous liquidity; Capital reallocation; Search.

JEL Classification: E22, E44, G11

Suggested Citation

Cao, Melanie and Shi, Shouyong, Endogenously Procyclical Liquidity, Capital Reallocation, and q (July 1, 2017). Available at SSRN: https://ssrn.com/abstract=2525544 or http://dx.doi.org/10.2139/ssrn.2525544

Melanie Cao

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 ext. 33801 (Phone)

Shouyong Shi (Contact Author)

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

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