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Liquidity Shocks and the Business Cycle

  • Bigio, Saki


    (Department of Economics, New York University)

This paper studies the properties of an economy subject to random liquidity shocks. As in Kiyotaki and Moore [2008], liquidity shocks affect the ease with which equity can be used as to finance the down-payment for new investment projects. We obtain a liquidity frontier which separates the state-space into two regions (liquidity constrained and unconstrained). In the unconstrained region, the economy behaves according to the dynamics of the standard real business cycle model. Below the frontier, liquidity shocks have the effects of investment shocks. In this region, investment is under-efficient and there is a wedge between the price of equity and the real cost of capital. As with investment shocks, we argue that liquidity shocks are not an important source of business cycle fluctuations in absence of other frictions affecting the labor market.

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Paper provided by Banco Central de Reserva del Perú in its series Working Papers with number 2010-005.

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Date of creation: May 2010
Date of revision:
Handle: RePEc:rbp:wpaper:2010-005
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  1. Alessandra Fogli & Laura Veldkamp, 2007. "Nature or Nurture? Learning and Female Labor Force Dynamics," Working Papers 07-12, New York University, Leonard N. Stern School of Business, Department of Economics.
  2. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2006. "Business cycle accounting," Staff Report 328, Federal Reserve Bank of Minneapolis.
  3. Vasco Cúrdia & Michael Woodford, 2010. "Conventional and unconventional monetary policy," Review, Federal Reserve Bank of St. Louis, issue May, pages 229-264.
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