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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.

Suggested Citation

  • Shouyong Shi, 2011. "Liquidity, Assets and Business Cycles," Working Papers tecipa-434, University of Toronto, Department of Economics.
  • Handle: RePEc:tor:tecipa:tecipa-434
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    References listed on IDEAS

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    Cited by:

    1. Andrea Ajello, 2016. "Financial Intermediation, Investment Dynamics, and Business Cycle Fluctuations," American Economic Review, American Economic Association, vol. 106(8), pages 2256-2303, August.
    2. Pablo A. Guerron-Quintana & Ryo Jinnai, "undated". "Liquidity, Trends and the Great Recession," Working Papers e66, Tokyo Center for Economic Research.
    3. Dong, Feng & Wang, Pengfei & Wen, Yi, 2018. "A Search-Based Neoclassical Model of Capital Reallocation," Working Papers 2018-17, Federal Reserve Bank of St. Louis.
    4. Cui, Wei, 2016. "Monetary–fiscal interactions with endogenous liquidity frictions," European Economic Review, Elsevier, vol. 87(C), pages 1-25.
    5. repec:eee:jbfina:v:89:y:2018:i:c:p:225-236 is not listed on IDEAS
    6. Hyunju Kang & Bok-Keun Yu & Jongmin Yu, 2016. "Global Liquidity and Commodity Prices," Review of International Economics, Wiley Blackwell, vol. 24(1), pages 20-36, February.
    7. Alexis Derviz, 2016. "Credit Constraints and Creditless Recoveries: An Unsteady State Approach," Working Papers 2016/10, Czech National Bank, Research Department.
    8. Yiting Li & Guillaume Rocheteau & Pierre-Olivier Weill, 2012. "Liquidity and the Threat of Fraudulent Assets," Journal of Political Economy, University of Chicago Press, vol. 120(5), pages 000.
    9. 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.
    10. Maurizio Iacopetta, 2014. "Dynamics of assets liquidity and inequality in economies with decentralized markets," Sciences Po publications info:hdl:2441/2029nqlehl8, Sciences Po.
    11. Jasmin Sin, 2016. "The Fiscal Multiplier in Small Open Economy; The Role of Liquidity Frictions," IMF Working Papers 16/138, International Monetary Fund.
    12. Marco Del Negro & Gauti Eggertsson & Andrea Ferrero & Nobuhiro Kiyotaki, 2017. "The Great Escape? A Quantitative Evaluation of the Fed's Liquidity Facilities," American Economic Review, American Economic Association, vol. 107(3), pages 824-857, March.
    13. Finocchiaro, Daria & Mendicino, Caterina, 2015. "Debt, equity and the Equity price puzzle," Working Paper Series 314, Sveriges Riksbank (Central Bank of Sweden).
    14. Soeren Radde & Wei Cui, 2013. "Search-Based Endogenous Illiquidity, Business Cycles and Monetary Policy," 2013 Meeting Papers 1009, Society for Economic Dynamics.
    15. Paweł Kopiec, 2018. "Interbank market turmoils and the macroeconomy," NBP Working Papers 280, Narodowy Bank Polski, Economic Research Department.
    16. repec:eee:eecrev:v:97:y:2017:i:c:p:108-130 is not listed on IDEAS
    17. Valerija Botric & Iva Tomic, 2016. "Self-employment of the young and the old: exploring effects of the crisis in Croatia," Working Papers 1603, The Institute of Economics, Zagreb.
    18. Jaccard, Ivan, 2013. "Liquidity constraints, risk premia, and themacroeconomic effects of liquidity shocks," Working Paper Series 1525, European Central Bank.
    19. repec:kap:jeczfn:v:123:y:2018:i:3:d:10.1007_s00712-017-0562-4 is not listed on IDEAS
    20. Ellington, Michael & Florackis, Chris & Milas, Costas, 2017. "Liquidity shocks and real GDP growth: Evidence from a Bayesian time-varying parameter VAR," Journal of International Money and Finance, Elsevier, vol. 72(C), pages 93-117.

    More about this item

    Keywords

    Liquidity; Asset prices; Business cycle;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G1 - Financial Economics - - General Financial Markets

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