Liquidity and the Allocation of Credit: Business Cycle, Government Debt and Financial Arrangements

Abstract

I analyze the equilibrium level of liquidity and its relevance for the allocation of credit across different technologies, when the notion of liquidity is related to private information. The general equilibrium analysis yields the following main implications: firstly, it provides an explanation of procyclical liquidity even in the presence of security endogeneity; secondly, it illustrates how government debt, by providing liquidity to an otherwise illiquid private market, encourages rather than crowds out private investment; thirdly, there is a well defined notion of collateral - the root of securities' value - the liquidity of which is endogenously enhanced by the arrangements within financial markets.

The approach is integrated because it jointly analyzes the three factors crucial to liquidity: (1) its level is endogenously determined through equilibrium pricing while entrepreneurs choose which security to issue; (2) the introduction of government debt has the two-fold effect of directly providing liquidity to entrepreneurs and indirectly influencing the kind of securities they issue in equilibrium; (3) financial markets develop arrangements to allow the beneficial employment of securities, not only physical assets, as collateral (financial pyramiding).

Keywords: Liquidity, endogenous securities, government debt, financial pyramiding

JEL Classification: E22, E32, E62, G14, G32