Liquidity Shocks and the Business Cycle

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.