Liquidity and Economic Fluctuations∗

This paper studies the relationship between liquidity and economic fluctuations when firms select the number of bonds they issue to finance investment opportunities on which they have private information. The dynamic of bond issuance and security design is the driving force delivering all the main results. First, the analysis provides a theoretical framework in which liquidity, investment and the variety of financial contracts are all procyclical; second, it argues that the theoretical implications of the model are consistent with two empirical US financial market regularities: (1) the negative correlation between the cross sectional variance in yields for firm debt and GDP growth and (2) the positive correlation between cross sectional variance in firm debt ratings and GDP growth. The approach also relates the illiquidity of the economy to the existence of pooling equilibria in the security space. This analysis shows how these kinds of equilibria become surprisingly robust to off-equilibrium perturbations. ∗A previous version of this paper received the European Economic Association "Young Economist Award". I am indebted to John Donaldson and Paolo Siconolfi for their constant encouragement. I have also greatly benefited from suggestions by an anonymous referee, Francesco Brindisi, Alberto Martin, and also Stefania Albanesi, Fernando Broner, Ron Findlay, Daniel Paravisini, Bruce Preston, Veronica Rappoport, Guido Sandleris, and seminar participants at various seminars. I gratefully acknowledge financial support from the Center for International Business and Economic Research at Columbia University. Heriberto Tapia provided excellent research assistance. †[email protected], School of International and Public Affairs, Columbia University, New York, NY.