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Competing Liquidities: Corporate Securities Real Bonds and Bubbles

  • Farhi, Emmanuel
  • Tirole, Jean

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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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 506.

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Date of creation: Mar 2008
Date of revision:
Handle: RePEc:ide:wpaper:8968
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  1. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  2. Saint-Paul, Gilles, 1992. "Fiscal Policy in an Endogenous Growth Model," The Quarterly Journal of Economics, MIT Press, vol. 107(4), pages 1243-59, November.
  3. Bordo, Michael D & Jeanne, Olivier, 2002. "Boom-Busts in Asset Prices, Economic Instability and Monetary Policy," CEPR Discussion Papers 3398, C.E.P.R. Discussion Papers.
  4. Ben S. Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
  5. 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.
  6. 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.
  7. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
  8. Jaume Ventura, 2002. "Bubbles and Capital Flows," NBER Working Papers 9304, National Bureau of Economic Research, Inc.
  9. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
  10. 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.
  11. 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.
  12. Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, vol. 53(6), pages 1499-1528, November.
  13. 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.
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