Liquidity, Assets and Business Cycles

Equity price is cyclical and often leads the business cycle by one or two quarters. These observations lead to the hypothesis that shocks to equity market liquidity are an independent source of the business cycle. In this paper I construct a model to evaluate this hypothesis. The model is easy for aggregation and for the construction of the recursive competitive equilibrium. After calibrating the model to the US data, I find that a negative liquidity shock in the equity market can generate large drops in investment and output but, contrary to what one may conjecture, the shock generates an equity price boom. This response of equity price occurs as long as a negative liquidity shock tightens firms' financing constraints on investment. Thus, liquidity shocks to the equity market cannot be the primary driving force of the business cycle. For equity price to fall as it typically does in a recession, a negative liquidity shock must be accompanied or caused by other shocks that reduce the need for investment sufficiently and relax firms' financing constraints on investment. I illustrate that a strong negative productivity shock is a good candidate of such concurrent shocks.