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Liquidity, Assets and Business Cycles

  • Shouyong Shi

I construct a tractable model to evaluate the liquidity shock hypothesis that exogenous shocks to equity market liquidity are an important cause of the business cycle. After calibrating the model, I find that a large and persistent negative liquidity shock can generate large drops in investment, employment and output. Contrary to the hypothesis, however, a negative liquidity shock generates an equity price boom. This counterfactual response of equity price is robust, provided that a negative liquidity shock tightens firms' financing constraint on investment. Also, I demonstrate that the same counterfactual response of equity price arises when there is a financial shock to a firm's collateral constraint on borrowing. For equity price to fall as it typically does in a recession, the negative liquidity/financial shock must be accompanied or caused by other changes that relax firms' financing constraint on investment. I discuss some candidates of these concurrent changes.

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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-459.

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Length: Unknown pages
Date of creation: 03 Jul 2012
Date of revision:
Handle: RePEc:tor:tecipa:tecipa-459
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  1. Russell Cooper & John Haltiwanger & Laura Power, 1995. "Machine Replacement and the Business Cycle: Lumps and Bumps," Papers 0062, Boston University - Industry Studies Programme.
  2. Williamson, Stephen D, 1987. "Financial Intermediation, Business Failures, and Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 95(6), pages 1196-1216, December.
  3. Ajello, Andrea, 2010. "Financial intermediation, investment dynamics and business cycle fluctuations," MPRA Paper 32447, University Library of Munich, Germany, revised Mar 2011.
  4. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
  5. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  6. Mark Doms & Timothy Dunne, 1994. "Capital Adjustment Patterns in Manufacturing Plants," Working Papers 94-11, Center for Economic Studies, U.S. Census Bureau.
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