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Liquidity and Spending Dynamics

Listed author(s):
  • Guido Lorenzoni

    (MIT)

  • Veronica Guerrieri

    (University of Chicago GSB)

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.

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File URL: https://economicdynamics.org/meetpapers/2007/paper_468.pdf
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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 468.

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Date of creation: 2007
Handle: RePEc:red:sed007:468
Contact details of provider: Postal:
Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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  1. Randall Wright & Guillame Rocheteau, 2003. "Money in Search Equilibrium, in Competitive Equilibrium, and in Competitive Search Equilibrium," Levine's Bibliography 666156000000000302, UCLA Department of Economics.
  2. Greenwood, Jeremy & Jovanovic, Boyan, 1990. "Financial Development, Growth, and the Distribution of Income," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages 1076-1107, October.
  3. Daron Acemoglu & Fabrizio Zilibotti, 1994. "Was Prometheus unbound by chance? Risk, diversification and growth," Economics Working Papers 98, Department of Economics and Business, Universitat Pompeu Fabra.
  4. P. A. Diamond, 1982. "Money in Search Equilibrium," Working papers 297, Massachusetts Institute of Technology (MIT), Department of Economics.
  5. John Moore & Nobuhiro Kiyotaki, "undated". "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  6. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
  7. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-419, June.
  8. Kiyotaki, Nobuhiro & Wright, Randall, 1989. "On Money as a Medium of Exchange," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 927-954, August.
  9. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-388, May.
  10. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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