Abstract
AbstractWe develop a search-theory of asset liquidity which gives rise to endogenous financing constraints on investment in an otherwise standard dynamic general equilibrium model. Asset liquidity describes the ease of issuance and resaleability of private financial claims, which is the outcome of a costly search-and-matching process for such claims implemented by financial intermediaries. Limited liquidity of private claims creates a role for liquid assets, such as government bonds, to ease financing constraints. We show that endogenising liquidity is essential to generate positive co-movement between asset liquidity and asset prices. When the cost of intermediating funds to entrepreneurs rises, investment and output fall whereas the hedging value of liquid assets increases, driving up liquidity premia. In the United States, such intermediation cost shocks can account for at least 37% of the variation in output, and more than 78% of the variation in liquidity premia.
Highlights
Asset market liquidity describes the ease with which financial claims can be traded and their price impact
How can these dynamic interactions between the macroeconomy and asset markets be captured in a standard macro model? We address this issue by developing a search theory of asset market liquidity which gives rise to endogenous financing constraints in general equilibrium
The demand-driven fall is reflected in the endogenous drop in asset saleability φ, which amplifies the initial shock in two ways: (1) it reduces the quantity of assets that entrepreneurs are able to sell; (2) the asset price, falls - though only modestly - in line with Proposition 2
Summary
Asset market liquidity describes the ease with which financial claims can be traded and their price impact. As regards the analysis of the impact of financial shocks on macroeconomic dynamics, our framework is related to Kiyotaki and Moore (2012) ( KM) and Shi (2015) These studies propose models with exogenous differences in the market liquidity between private claims and government-issued assets to study the macroeconomic impact of liquidity shocks. The model features liquidity and financing constraints on primary and secondary asset markets, liquid assets as the lubricant of investment financing, and feedback effects between asset liquidity and the real economy In this regard, our paper is related to Yang (2014) and Cao and Shi (2014), which apply search theory to asset or capital markets. Cui and Radde (2016) does not offer insights into the dynamic behaviour of asset liquidity including the distinct role of financial shocks as an important source of business cycles
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