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Liquidity, Assets and Business Cycles

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  • Shouyong Shi

Abstract

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.

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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-434.

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Length: Unknown pages
Date of creation: 14 Jun 2011
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Handle: RePEc:tor:tecipa:tecipa-434

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Keywords: Liquidity; Asset prices; Business cycle;

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  1. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, Elsevier, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  2. Williamson, Stephen D, 1987. "Financial Intermediation, Business Failures, and Real Business Cycles," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 95(6), pages 1196-1216, December.
  3. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, Elsevier, vol. 49(1), pages 75-97, January.
  4. John Haltiwanger & Russell Cooper & Laura Power, 1999. "Machine Replacement and the Business Cycle: Lumps and Bumps," American Economic Review, American Economic Association, American Economic Association, vol. 89(4), pages 921-946, September.
  5. Mark E. Doms & Timothy Dunne, 1998. "Capital Adjustment Patterns in Manufacturing Plants," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(2), pages 409-429, April.
  6. Ajello, Andrea, 2010. "Financial intermediation, investment dynamics and business cycle fluctuations," MPRA Paper 32447, University Library of Munich, Germany, revised Mar 2011.
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Cited by:
  1. Engin Kara & Jasmin Sin, 2013. "Liquidity, Quantitative Easing and Optimal Monetary Policy," Bristol Economics Discussion Papers 13/635, Department of Economics, University of Bristol, UK.
  2. Yiting Li & Guillaume Rocheteau & Pierre-Olivier Weill, 2011. "Liquidity and the threat of fraudulent assets," Working Paper 1124, Federal Reserve Bank of Cleveland.
  3. Soeren Radde & Wei Cui, 2013. "Search-Based Endogenous Illiquidity, Business Cycles and Monetary Policy," 2013 Meeting Papers, Society for Economic Dynamics 1009, Society for Economic Dynamics.
  4. Ajello, Andrea, 2010. "Financial intermediation, investment dynamics and business cycle fluctuations," MPRA Paper 32447, University Library of Munich, Germany, revised Mar 2011.
  5. Jaccard, Ivan, 2013. "Liquidity constraints, risk premia, and themacroeconomic effects of liquidity shocks," Working Paper Series, European Central Bank 1525, European Central Bank.

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