Liquidity and Spending Dynamics

How do financial frictions affect the response of an economy to aggregate shocks? In this paper, we address this question, focusing on liquidity constraints and uninsurable idiosyncratic risk. We consider a search model where agents use a liquid asset to smooth individual income shocks. We show that the response of this economy to aggregate shocks depends on the rate of return on liquid assets. When liquid assets pay a low return, agents hold smaller liquidity reserves and the response of the economy tends to be larger. In this case, agents expect to be liquidity constrained and, due to a precautionary motive, their consumption decisions respond more to changes in expected income. On top of this, there is a general equilibrium effect that magnifies the economy response. After a positive aggregate shock, agents' consumption increases and this raises income expectations, further reducing the precautionary demand for liquid assets. On the other hand, when liquid assets pay a large return, agents hold larger reserves and their consumption decisions are more insulated from income uncertainty. In this case, the equilibrium achieves the first-best allocation and the response to aggregate shocks tends to be smaller.