Liquidity Constraints and Business Cycles

Abstract

This paper studies quantitative properties of the models of Kiyotaki and Moore (2001, 2008, 2012) which investigate propagation mechanism through which asset market liquidity affects real economy. The distinct analytical focus in this paper is on the effects of redistribution of wealth between agents due to investment opportunities. Under binding liquidity constraints faced by investors, the impacts of liquidity crunch are propagated to real economy via investment shrinkage. Numerical analyses reveal that the effects of liquidity shocks are amplified when the redistribution of wealth are more prominent. However, liquidity shocks in the secondary market, i.e., in the resaleability of assets, do not seem to be quantitatively significant driving forces of business cycles, at least compared to the ones in the primary market. This study confirmed the negatively correlated responses to liquidity shocks between investment and asset prices, and between investment and consumption, which are already pointed out in the literature. More importantly, this study newly found that liquidity premium in the model positively responded not only to liquidity crunch but also to positive productivity shocks. This pro-cyclicality of liquidity premium needs careful considerations since it can be another arguable defect of the model.