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Liquidity and Trading Dynamics

Veronica Guerrieri and Guido Lorenzoni

No 13204, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: How do financial frictions affect the response of an economy to aggregate shocks? In this paper, we address this question, focusing on liquidity constraints and uninsurable idiosyncratic risk. We consider a search model where agents use liquid assets to smooth individual income shocks. We show that the response of this economy to aggregate shocks depends on the rate of return on liquid assets. In economies where liquid assets pay a low return, agents hold smaller liquid reserves and the response of the economy tends to be larger. In this case, agents expect to be liquidity constrained and, due to a self-insurance motive, their consumption decisions are more sensitive to changes in expected income. On the other hand, in economies where liquid assets pay a large return, agents hold larger reserves and their consumption decisions are more insulated from income uncertainty. Therefore, aggregate shocks tend to have larger effects if liquid assets pay a lower rate of return.

JEL-codes: D83 E41 E44 (search for similar items in EconPapers)
Date: 2007-06
New Economics Papers: this item is included in nep-bec, nep-dge and nep-mac
Note: EFG ME
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Published as Veronica Guerrieri & Guido Lorenzoni, 2009. "Liquidity and Trading Dynamics," Econometrica, Econometric Society, vol. 77(6), pages 1751-1790, November.

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