With Sören Radde. Journal of the European Economic Association, 2020.
This paper develops a macroeconomic theory of endogeneous asset liquidity. The ease with which private financial claims can be issued and resold is determined by costly search and matching in financial markets. When financial intermediation becomes more difficult, private assets become less liquid, financing constraints tighten, and investment and output fall. At the same time, demand for liquid assets such as government bonds rises, generating flight-to-liquidity dynamics and higher liquidity premia.
Three main findings:
Asset liquidity depends on the participation decisions of both buyers and sellers. Endogenising these decisions generates the positive comovement between asset saleability and asset prices observed over the business cycle. Models with exogenous liquidity shocks instead tend to predict rising asset prices when market liquidity deteriorates.
Higher intermediation costs reduce investors’ demand for private financial claims, restrict entrepreneurs’ access to external finance, and lower investment and output. In the calibrated model, these shocks account for about 37% of fluctuations in U.S. output and more than 78% of fluctuations in liquidity premia.
Government bonds or money can be used readily when private claims are difficult to issue or resell. Their hedging value therefore rises during financial downturns. Private and public liquidity coexist when financial-market frictions are intermediate, while sufficiently severe intermediation frictions can cause private asset markets to break down.
This paper connects search-based theories of asset trading with macroeconomic models of financing constraints. It provides a framework for studying liquidity cycles, flight to liquidity, market-based financial intermediation, safe-asset demand, and the feedback between asset-market liquidity and the real economy.