November 15, 2016, 17:00–18:30
Room MS 001
We develop a search-theory of asset market liquidity which gives rise to endogenous financing constraints in an otherwise standard dynamic general equilibrium model. Asset liquidity describes the ease of issuance and resaleability of private financial claims for a certain price. We model asset liquidity as an outcome of the participation margins of buyers and sellers on an asset market, where financial intermediaries implement a costly search-and-matching process. Limited market liquidity of private claims creates a role for liquid assets, such as fiat money, to ease financing constraints. We show that endogenising liquidity is essential to generate positive co-movement between asset (re)saleability and asset prices. When the capacity of the asset market to channel funds to entrepreneurs deteriorates, investment falls while the hedging value of liquid assets increases, driving up liquidity premia. Our model, thus, demonstrates that shocks to the intermediation capacity of financial markets can be an important source of flight to- liquidity dynamics and macroeconomic fluctuations, matching key business cycle characteristics of the U.S. economy.