Endogenously Procyclical Liquidity, Capital Reallocation, and q

Shouyong Shi and Melanie Cao

No 100, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: By analyzing a stochastic equilibrium with endogenous liquidity in the capital market, this paper explains the puzzling fact that capital reallocation across firms is procyclical while dispersion in Tobin's q across firms is acyclical or counter cyclical. Capital is reallocated across firms through a frictional market modeled by search and matching. The market tightness captures liquidity in this market and is endogenously determined as buyers choose whether to enter the market. Capital creation is also endogenous as capital makers choose whether to incur a cost to make capital. When aggregate productivity increases, more capital is created. At the same time, more buyers enter the capital market to buy capital in an attempt to capture the increased value of a productive firm. As a result, market liquidity increases and more capital is reallocated. The price of capital increases, which increases q of low-value firms and reduces q of high-value firms. The mean and standard deviation in q across firms respond ambiguously to an increase in aggregate productivity. These results are robust to the addition of heterogeneity in firm-specific productivity.

Date: 2015
New Economics Papers: this item is included in nep-bec, nep-dge and nep-mac
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