Liquidity, Assets and Business Cycles

37 Pages Posted: 24 May 2011 Last revised: 2 Jul 2012

Shouyong Shi

Pennsylvania State University

Date Written: September 27, 2011

Abstract

I construct a tractable model to evaluate the liquidity shock hypothesis that exogenous shocks to equity market liquidity are an important cause of the business cycle. After calibrating the model, I find that a large and persistent negative liquidity shock can generate large drops in investment, employment and output. Contrary to the hypothesis, however, a negative liquidity shock generates an equity price boom. This counterfactual response of equity price is robust, provided that a negative liquidity shock tightens firms' financing constraint on investment. Also, I demonstrate that the same counterfactual response of equity price arises when there is a financial shock to a firm's collateral constraint on borrowing. For equity price to fall as it typically does in a recession, the negative liquidity/financial shock must be accompanied or caused by other changes that relax firms' financing constraint on investment. I discuss some candidates of these concurrent changes.

Keywords: Liquidity, Asset prices, Business Cycle

JEL Classification: E32, E5, G1

Suggested Citation

Shi, Shouyong, Liquidity, Assets and Business Cycles (September 27, 2011). Available at SSRN: https://ssrn.com/abstract=1845988 or http://dx.doi.org/10.2139/ssrn.1845988

Shouyong Shi (Contact Author)

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

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