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Liquidity shocks, business cycles and asset prices

Saki Bigio and Andrés Schneider

European Economic Review, 2017, vol. 97, issue C, 108-130

Abstract: In the aftermath of the Great Recession, macro models that feature financing constraints have attracted increasing attention. Among these, Kiyotaki et al. (2012) is a prominent example. In this paper, we investigate whether the liquidity shocks and financial frictions proposed by Kiyotaki et al. (2012) can improve the asset pricing predictions of the frictionless RBC model. We study the quantitative business cycle and asset pricing properties in an economy in which agents feature recursive preferences, are subject to a liquidity constraint, and suffer liquidity shocks. We find that the model predicts highly nonlinear time variation and levels of risk premia, which are driven by endogenous fluctuations in equity prices. However, the model fails to account for a basic fact: Periods of scarce liquidity are associated with high asset prices and low expected returns.

Keywords: Business cycles; Investment; Asset prices; Liquidity (search for similar items in EconPapers)
JEL-codes: E22 E32 E44 G12 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:eee:eecrev:v:97:y:2017:i:c:p:108-130