On Liquidity Shocks and Asset Prices

Abstract

AbstractIn models of financial frictions, stock market booms tend to follow adverse liquidity shocks. This finding is clearly at odds with the data. We demonstrate that this counterfactual result is specific to real business cycle models with exogenous growth. Once we allow for both endogenous productivity and growth, this puzzling price dynamic easily disappears. Intuitively, the gloomy economic‐growth outlook following an adverse liquidity shock generates a predictable and negative long‐run component in dividend growth, leading to the collapse of equity prices.