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Endogenously Procyclical Liquidity, Capital Reallocation, and q

56 Pages Posted: 17 Nov 2014 Last revised: 3 Oct 2017

Melanie Cao

York University - Schulich School of Business

Shouyong Shi

Pennsylvania State University

Date Written: July 2017

Abstract

Capital reallocation is procyclical and dispersion in Tobin's q across firms is counter-cyclical or acyclical. These facts run counter to the Schumpeterian view of capital reallocation embodied in modern theories of business cycles. To resolve the puzzles, 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 capital market liquidity is procyclical endogenously, generated by the entry of buyers into the market. We characterize the stochastic equilibrium analytically to prove that when aggregate productivity increases, the amount and the price of reallocated capital increase while dispersion in q responds ambiguously. The model is also calibrated to the data to simulate the equilibrium response to the aggregate shock. Moreover, we incorporate firm-specific productivity and an endogenous supply of used capital to show that endogenous liquidity can dominate the cleansing effect of a recession so that capital reallocation remains procyclical.

Keywords: Endogenous liquidity, Capital reallocation, Tobin's q, Frictions

JEL Classification: E22, E44, G11

Suggested Citation

Cao, Melanie and Shi, Shouyong, Endogenously Procyclical Liquidity, Capital Reallocation, and q (July 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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