Liquidity, Assets and Business Cycles
Pennsylvania State University
September 27, 2011
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.
Number of Pages in PDF File: 37
Keywords: Liquidity, Asset prices, Business Cycle
JEL Classification: E32, E5, G1
Date posted: May 24, 2011 ; Last revised: July 2, 2012