Liquidity and Economic Fluctuations

Abstract

This paper studies the relationship between liquidity and economic fluctuations when firms endogenously select their leverage level to finance investment opportunities on which they have private information. The dynamic of bond issuance and security design is the driving force delivering all the main results. First, the analysis provides a theoretically based measure of the liquidity of the economy, i.e. the cross sectional variance in firm debt yields. Second, it shows why liquidity, investment and the dispersion of leverage levels observed in the bond markets should be procyclical. Third, it argues that the theoretical implications of the model are consistent with two novel US financial market regularities: (1) the negative correlation between the cross sectional variance in firm debt yields and the cyclical component of GDP and (2) the positive correlation between cross sectional variance in firm debt ratings and the cyclical component of GDP. The approach also relates the illiquidity of the economy to the existence of pooling equilibria in the security space. This analysis shows how these kinds of equilibria become surprisingly robust to off-equilibrium perturbations.

Keywords: Liquidity, Economic Fluctuations, Asymmetric Information

JEL Classification: E44, G14