With Randall Wright and Yu Zhu. Journal of Political Economy, 2025.
This paper studies how liquidity and credit conditions affect the reallocation of productive capital across firms. Firms acquire capital in centralized primary markets and, after idiosyncratic productivity shocks, retrade it in decentralized secondary markets with search, bargaining, and payment frictions. A key distinction is between full sales, in which a more productive buyer acquires all the seller’s capital, and partial sales, in which limited liquidity prevents complete reallocation.
With constant returns to scale, productive efficiency requires capital to move entirely to the more productive firm. But financially constrained buyers may lack sufficient money or credit to complete the transaction. Poor liquidity therefore reduces total reallocation and replaces efficient full sales with partial sales, leaving capital in less productive uses.
Higher trend inflation raises the cost of holding liquid assets, reducing full sales and increasing the relative importance of partial sales. At business-cycle frequencies, easier credit raises total reallocation and full sales, reduces partial sales, and lowers money demand—producing a short-run rise in the price level. The model therefore explains why inflation and full sales move negatively in the longer run but positively over the business cycle.
The ease with which firms can resell capital affects how much they initially invest in primary markets. Search frictions, bargaining power, monetary liquidity, and credit availability jointly shape investment, output, aggregate productivity, and welfare. Because inflation can have nonmonotonic effects and interact with bargaining distortions, the Friedman rule need not always be the optimal monetary policy.