Precautionary Saving and Liquidity Shortage

Abstract

Most of the canonical macroeconomic models simulate liquidity anomalies by changing the economic fundamentals or adding massive financial shock to firms’ collateral constraints, but a few facts somehow tell a different story. Instead of relying on the exogenous shocks, we introduce uncertainty into an otherwise classical liquidity framework and try to answer what worsens the aggregate liquidity in the absence of exogenous simulations and what a firm dynamics and financing strategy would be. Our analysis shows that (1) uncertainty induces agents to make decisions under the worst-case scenario and hence generates a unique expectation threshold that drags market (or firms) liquidity from sufficiency to insufficiency even without any shock or economic changes. (2) Precautionary saving occurs before the real liquidity shortage as the expectation shifts, causing firms to secure external financing by raising the equity issuing price and hoarding liquid assets, such as fiat money, against liquidity tightening. (3) To achieve liquidity stability and sustainability, an extra mathematical constraint is supplemented for the uniqueness and the existence of equilibrium under uncertainty. Other properties of firms’ intertemporal allocations, such as the bid-ask spread and return of holding of the illiquid asset, are derived. Moreover, some approaches for further empirical research are discussed.