Liquidity, Assets and Business Cycles

Equity price is cyclical and often leads the business cycle. These observations have led to the hypothesis that shocks to equity market liquidity are an independent source of the business cycle. In this paper I construct a tractable model to evaluate this hypothesis. After calibrating the model to the US data, I find that a negative liquidity shock in the equity market can generate large reductions in investment, employment and output but, opposite to what is observed in recessions, the shock generates an equity price boom. I demonstrate that this counterfactual response of equity price to liquidity shocks is not unique to the particular model here; rather, it is a robust feature of many models where equity is important either as a direct means of financing investment or as collateral for borrowing in investment finance. The culprit of this counterfactual response is the effect that a negative liquidity shock tightens a firm’s financing constraint, which is intuitively what the shock is supposed to do. This robust result indicates that liquidity shocks to the equity market are unlikely to 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 relax firms’ financing constraints on investment. I illustrate that a strong negative productivity shock is a good candidate of such concurrent shocks. JEL classifications: E32; E5; G1