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Competing Liquidities: Corporate Securities, Real Bonds and Bubbles

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  • Emmanuel Farhi
  • Jean Tirole

Abstract

We explore the link between liquidity and investment in a an overlapping generation model with a standard asynchronicity between firms' access to and need for cash. Imperfect pledgeability hinders the capacity of capital markets to resolve this asynchronicity, resulting in credit rationing and a net demand for stores of value -- liquidity -- by the corporate sector. At the heart of the model is a distinction between inside liquidity -- liquidity created within the private sector -- and outside liquidity -- assets that do not originate in private investment decisions. In the model, outside liquidity comes in two forms: rents and asset bubbles. We make four contributions. First, we show that imperfect pledgeability severs the link between dynamic efficiency and the level of the interest rate. Bubbles are possible even when the economy is dynamically efficient. Second, we demonstrate that the link between outside liquidity and investment is ambiguous: on the one hand, outside liquidity eases the asynchronicity problem of firms, boosting investment -- the liquidity effect; on the other hand it competes with inside liquidity, reduces the value of firms' collateral and lowers investment -- the competition effect. We characterize precisely the conditions under which outside liquidity and investment are complements or substitutes. Third, we explore the possibility of stochastic bubbles. We show that they trade at a liquidity discount. Bubble bursts can be endogenously triggered by bad shocks to corporate balance sheets and have potentially amplified effects on investment through liquidity dry-ups. Fourth, in an extension where corporate governance is endogenously determined by a trade-off striked by firms between collateral and value, we show that bubbles are accompanied by loose corporate governance.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13955.

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Date of creation: Apr 2008
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Publication status: published as “ Bubbly Liquidity” (with Jean Tirole) Review of Economic Studies, February 2012, vol 79 (2)
Handle: RePEc:nbr:nberwo:13955

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  1. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2006. "Bubbles and capital flow volatility: Causes and risk management," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 35-53, January.
  2. Ben Bernanke & Mark Gertler, 2000. "Monetary Policy and Asset Price Volatility," NBER Working Papers 7559, National Bureau of Economic Research, Inc.
  3. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Abel, Andrew B, et al, 1989. "Assessing Dynamic Efficiency: Theory and Evidence," Review of Economic Studies, Wiley Blackwell, vol. 56(1), pages 1-19, January.
  5. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  6. Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, vol. 53(6), pages 1499-1528, November.
  7. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  8. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
  9. Michael D. Bordo & Olivier Jeanne, 2002. "Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy," NBER Working Papers 8966, National Bureau of Economic Research, Inc.
  10. Gilles Saint-Paul, 2005. "Fiscal Policy and Economic Growth: the Role of Financial Intermediation," Review of International Economics, Wiley Blackwell, vol. 13(3), pages 612-629, 08.
  11. Weil, Philippe, 1987. "Confidence and the Real Value of Money in an Overlapping Generations Economy," The Quarterly Journal of Economics, MIT Press, vol. 102(1), pages 1-22, February.
  12. Jaume Ventura, 2002. "Bubbles and Capital Flows," NBER Working Papers 9304, National Bureau of Economic Research, Inc.
  13. Saint-Paul, G., 1991. "Fiscal Policy In An Endogenous Growth Model," DELTA Working Papers 91-04, DELTA (Ecole normale supérieure).
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Cited by:
  1. Stefano Giglio & Tiago Severo, 2011. "Intangible Capital, Relative Asset Shortages and Bubbles," Levine's Working Paper Archive 786969000000000121, David K. Levine.
  2. Bertrand Wigniolle, 2012. "Optimism, pessimism and financial bubbles," Documents de travail du Centre d'Economie de la Sorbonne 12005, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
  3. Andrei Shleifer & Robert W. Vishny, 2009. "Unstable Banking," NBER Working Papers 14943, National Bureau of Economic Research, Inc.
  4. Pengfei Wang & Yi Wen, 2012. "Speculative Bubbles and Financial Crises," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(3), pages 184-221, July.
  5. repec:hal:wpaper:halshs-00587686 is not listed on IDEAS

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