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Liquidity and Trading Dynamics

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  • Veronica Guerrieri
  • Guido Lorenzoni

Abstract

How do financial frictions affect the response of an economy to aggregate shocks? In this paper, we address this question, focusing on liquidity constraints and uninsurable idiosyncratic risk. We consider a search model where agents use liquid assets to smooth individual income shocks. We show that the response of this economy to aggregate shocks depends on the rate of return on liquid assets. In economies where liquid assets pay a low return, agents hold smaller liquid reserves and the response of the economy tends to be larger. In this case, agents expect to be liquidity constrained and, due to a self-insurance motive, their consumption decisions are more sensitive to changes in expected income. On the other hand, in economies where liquid assets pay a large return, agents hold larger reserves and their consumption decisions are more insulated from income uncertainty. Therefore, aggregate shocks tend to have larger effects if liquid assets pay a lower rate of return.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13204.

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Date of creation: Jun 2007
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Publication status: published as Veronica Guerrieri & Guido Lorenzoni, 2009. "Liquidity and Trading Dynamics," Econometrica, Econometric Society, vol. 77(6), pages 1751-1790, November.
Handle: RePEc:nbr:nberwo:13204

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Citations

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Cited by:
  1. Xavier Ragot & Edouard Challe, 2011. "Precautionary Saving over the Business Cycle," 2011 Meeting Papers 517, Society for Economic Dynamics.
  2. Francesco Lippi & Nicholas Trachter, 2011. "The optimum Quantity of Money with Borrowing Constraints," EIEF Working Papers Series 1108, Einaudi Institute for Economics and Finance (EIEF), revised Apr 2011.
  3. Guillaume Rocheteau & Randall Wright, 2010. "Liquidity and asset market dynamics," Working Paper 1016, Federal Reserve Bank of Cleveland.
  4. Fabrizio Perri & Jonathan Heathcote, 2011. "Wealth and Volatility," 2011 Meeting Papers 1065, Society for Economic Dynamics.
  5. Veronica Guerrieri & Guido Lorenzoni, 2011. "Credit Crises, Precautionary Savings, and the Liquidity Trap," NBER Working Papers 17583, National Bureau of Economic Research, Inc.
  6. Francesco Lippi & Stefania Ragni & Nicholas Trachter, 2013. "State Dependent Monetary Policy," EIEF Working Papers Series 1324, Einaudi Institute for Economics and Finance (EIEF), revised Sep 2013.
  7. Williamson, Stephen & Wright, Randall, 2010. "New Monetarist Economics: Models," Handbook of Monetary Economics, Elsevier, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 2, pages 25-96 Elsevier.
  8. Veronica Guerrieri & Peter Kondor, 2012. "Fund Managers, Career Concerns, and Asset Price Volatility," American Economic Review, American Economic Association, American Economic Association, vol. 102(5), pages 1986-2017, August.
  9. repec:fip:fedreq:y:2011:i:3q:p:209-254:n:vol.97no.3 is not listed on IDEAS
  10. repec:hal:wpaper:hal-00843150 is not listed on IDEAS
  11. Guido Lorenzoni, 2007. "Inefficient Credit Booms," NBER Working Papers 13639, National Bureau of Economic Research, Inc.

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