Endogenously Procyclical Liquidity, Capital Reallocation, and q
56 Pages Posted: 17 Nov 2014 Last revised: 3 Oct 2017
Date Written: July 2017
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: Suggested Citation