Liquidity and Trading Dynamics

48 Pages Posted: 3 Jul 2007 Last revised: 30 Jan 2022

See all articles by Veronica Guerrieri

Veronica Guerrieri

University of Chicago - Booth School of Business

Guido Lorenzoni

Northwestern University; National Bureau of Economic Research (NBER)

Date Written: June 2007

Abstract

How do financial frictions affect the response of an economy to aggregate shocks? In this paper, we address this question, focusing on liquidity constraints and uninsurable idiosyncratic risk. We consider a search model where agents use liquid assets to smooth individual income shocks. We show that the response of this economy to aggregate shocks depends on the rate of return on liquid assets. In economies where liquid assets pay a low return, agents hold smaller liquid reserves and the response of the economy tends to be larger. In this case, agents expect to be liquidity constrained and, due to a self-insurance motive, their consumption decisions are more sensitive to changes in expected income. On the other hand, in economies where liquid assets pay a large return, agents hold larger reserves and their consumption decisions are more insulated from income uncertainty. Therefore, aggregate shocks tend to have larger effects if liquid assets pay a lower rate of return.

Suggested Citation

Guerrieri, Veronica and Lorenzoni, Guido, Liquidity and Trading Dynamics (June 2007). NBER Working Paper No. w13204, Available at SSRN: https://ssrn.com/abstract=997560

Veronica Guerrieri

University of Chicago - Booth School of Business ( email )

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Guido Lorenzoni (Contact Author)

Northwestern University ( email )

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National Bureau of Economic Research (NBER) ( email )

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