Liquidity, Business Cycles, and Monetary
PolicyNobuhiro Kiyotaki and John Moore
First version, June 2001
This version, April 2008

Abstract
This paper presents a model of monetary economy with di¤erences in liquidity across assets. Our purpose is to study how aggregate production and asset prices ‡uctuate with shocks to productivity
and liquidity. In so doing, we examine what role government policy
might have through open market operations that change the mix ofassets held by the private sector. We also show that certain apparent
anomalies of asset markets are in fact normal features of a monetary
economy in which the circulation of money is essential for a better
allocation of resources.
Princeton University, Edinburgh University and London School of Economics. We
are grateful for feedback from participants of seminars and conferences. In particular,
we would like to thank Daron Acemoglu, Olivier Blanchard, Markus Brunnermeier, Ricardo Caballero, V.V. Chari, Edward Green, Bengt Holmstrom, Olivier Jeanne, Narayana
Kocherlakota, Robert Lucas, Kiminori Matsuyama, Ellen McGrattan, Hyun Shin, RobertTownsend, Neil Wallace and Ruilin Zhou for very helpful discussions and criticisms. Thisis still very preliminary, (Conclusion and Appendix to be completed), despite of a longgestation lag. Please do not quote nor circulate without the authors’permission.

1

1

Introduction

In this paper, we provide a model of monetary economy with di¤erences inliquidity across assets. Our purpose is to understand how aggregate production and asset prices ‡uctuate with recurrent shocks to productivity andliquidity. In so doing, we want to …nd out what role government policy
might have through open market operations that change the mix of assets
held by the private sector. The present paper takes …at money to be oneof the assets under consideration. We investigate under what circumstancesmoney is essential to a better allocation of resources. We show that certain
apparent anomalies of the non-monetary economy are in fact normal featuresof an economy where money is essential. Among the well-known puzzles wehave in mind are: the low risk-free rate puzzle; the excess volatility of asset
prices; the anomalous savings behaviour of certain households, and their low
participation in asset markets. Before describing our monetary economy, we
should start with some remarks about modeling strategy.
In broad terms, there are two ways of getting …at money into a competitive macroeconomic model. One approach is to endow money with somespecial function – for example, cash-in-advance or sticky nominal prices.1
The other approach is to starve agents of alternatives to money – as in an
overlapping generations framework where money is the sole means of saving.2
Although the …rst approach, in particular the cash-in-advance model and the
dynamic sticky price model, has proved important to monetary economics
and policy analysis, it is not well-suited to answering larger questions to dowith liquidity. By endowing money with a special function in the otherwise
frictionless economy with complete Arrow-Debreu security market, one is
imposing rather than explaining the use of money, which precludes the possibility that other assets or media of denomination may substitute for money.
And the second approach rules out any general discussion of liquidity if there
are no alternative assets to money.
There are many noncompetitive models of money, leading with the random matching framework. In principle, such models are suited to analyzing
liquidity. But they are necessarily special, and it is di¢ cult to incorporate
them into the rest of macroeconomics.3 We believe there is a need for a work1

See Clower (1967), Lucas and Stokey (1987) and Woodford (2003).
P.A.Samuelson (1958). Bewley (1980) also models money in a context where there are
no alternative assets with which to save.
3
See Kiyotaki and Wright (1989) and Du¢ e, Garleanu and Pedersen (2005) for exam2

2

horse model of money and liquidity, with competitive markets, which does
not stray too far from the other workhorse, the real business cycle model.
In our framework, markets are competitive, money is not endowed withany special function, and there are other assets traded besides money. The
basic model presented in Section 2 has two kinds of agents, entrepreneurs andworkers, homogeneous general output, and three assets: …at money, physicalcapital (or equity of physical capital), and human capital. The supply of…at money is …xed. The supply of capital changes through investment anddepreciation. A worker’s human capital is inalienable, which means that heor she cannot borrow against future labour income: in any period, the only
labour market is a spot market for that period’s labour services. There is acommonly available technology for combining labour with capital to produce
general output.
In each period a fraction of the entrepreneurs (but none of the workers) can invest in producing new capital from general output. The arrivalof such an investment opportunity is randomly distributed across entrepreneurs through time. Because not all entrepreneurs can invest in each period,
there is a need to transfer resources from those who don’t have an investment
opportunity (that period’s savers) to those who do (that period’s investors).
To acquire general output as input for the production of new capital, investing entrepreneurs sell equity claims to the future returns from the newly
produced capital. The crucial feature of the model is that, because the investing entrepreneur is still needed to run the project to produce output andhe cannot precommit to work throughout its life, he is able to pledge only
a fraction (say ) of future returns from the new capital. As the investing
entrepreneur can only issue new equity up to fraction of his investment, hefaces a borrowing constraint.
Because of the borrowing constraint, the investing entrepreneur needs to…nance the investment cost partly by selling his holding of money and equityof the other agents (which he acquired in the past). Another importantfeature of our model is that the existing equity (the claim to the return ofthe existing capital stock) cannot be sold as quickly as money. Speci…cally,
we assume that, in any given period t, an agent can sell only a fraction tof his equity holding. In contrast to the upper bound of new equity issue
ples. For recent attempts to make matching models applicable for policy analysis, seeLagos and Wright (2005), Huang and Wright (2005, 2008) and Aruoba, Waller and Wright(2007).

3

, the value of t is the limit that the investing entrepreneur can resell his
equity holding before he misses the investment opportunity. Thus, we callas borrowing constraint, call t as "resaleability constraint", and call bothconstraints together as "liquidity constraints". Here, we take both and t
as exogenous parameters and consider a stochastic shock to t as "liquidity
shock".4;5
The question is to what extent does these liquidity constraints inhibit
the e¢ cient transfer of resources from savers to investors. There may be arole for money to lubricate the transfer of additional resources. Whether or
not agents use money is determined endogenously. We show that for highenough values of and average t money is not used and has no value inthe neighbourhood of the steady state. But for lower values of and averaget , money plays an essential role. In the latter case, we call the economy amonetary economy.
We …nd that a necessary feature of a monetary economy is that the investment of entrepreneurs is limited by liquidity constraints. He cannot raise
the entire cost of investment externally, given that the borrowing constraint
binds for the sale of new equity. That is, he has to make a downpayment
for each unit of investment from his own internal funds. But in trying toraise funds to make this downpayment, he is constrained by how much of his
equity holding can be sold in time: the resaleability constraint binds here. In
this sense, an investing entrepreneur …nds money more valuable than equity,
because he can use all of his money to …nance new investment whereas hecan use only a fraction t of his equity: money is more liquid than equity.6
4
In Kiyotaki and Moore (2003, 2005b), we develop a framework in which the resaleability constraint arises endogenously due to adverse selection in resale market. Each newcapital comprises a large number of parts, some of which will eventually fail (depreciatecompletely), although nobody knows which when the new capital is produced. Overtime,the insiders (producing entrepreneurs and those who bought the new equity) learn privately which parts will fail. If the fraction of failing parts is large enough, no outsider
will buy second-hand equity for fear of being sold lemons.
In order to overcome the adverse selection problem, the investing entrepreneur can spend
extra resource to bundle all the parts of the new capital together in such a way that theycannot later unbundled. Then the equity issued against bundled new capital will be resold
freely.
5
In the analysis of …nancial market, Brunnermeier and Perdersen (2007) use notion of"funding liquidity" to refer borrowing constraint and "market liquidity" to refer resaleability constraint.
6
In practice, there are clearly di¤erences between kinds of equities –e.g. betweeen theshare of a large publicly-traded company and stock of a small privately-held business.

4

We …nd that in a monetary economy, the rate of return on money isvery low, less than the return on equity. Nevertheless, a saving entrepreneurchooses to hold some money in his portfolio, because, in the event that hehas an opportunity to invest in the future, he will be liquidity constrained,
and money is more liquid than equity. The gap between the return on money
and the return on equity is a liquidity premium. This may help explain the
low risk-free rate puzzle.
We also …nd that both the returns on equity and money are lower than
the rate of time preference. This means that agents such as workers, who
don’t anticipate having investment opportunities, will choose to hold neither
equity nor money. They will simply consume their labour income, period
by period. This may help explain why certain households do not save nor
participate in asset markets. It is not that they don’t have free access toasset markets nor that they are particularly impatient, but rather that thereturn on assets isn’t enough to attract them.7
In most real business cycle models, there is no feedback from asset market
to output. That is not true in our monetary economy. Consider a shock which
reduces resaleability of equity t persistently. (This liquidity shock is meant
to capture an aspect of the recent …nancial turmoil in which many assets such as auction rate bonds - that used to be liquid suddenly have become
only partially resaleable). Then, the amount the investing entrepreneurs
can use as downpayment for investment shrinks. Moreover, anticipating alower resaleability, the equity price falls, which can be thought as "a ‡ight
to liquidity". This raises the size of the required downpayment per unitof new investment. Altogether, investment su¤ers from the negative shockto the resaleability of equity. This feedback mechanism causes asset prices
and investment to be vulnerable to liquidity shocks unlike standard generalequilibrium asset pricing model without liquidity constraints.
In a later section of the paper we introduce government. Our interest
is in seeing the e¤ect of policy on the behaviour of the private economy.
We consider that the government holds equity and can costlessly change thesupply of …at money. In our framework with ‡exible prices, a change ofmoney supply through lump-sum transfer to the entrepreneurs (helicopterdrop) does not have any e¤ect on aggregate real variables. The open market
operation to purchase equity by issuing money, however, will increase the7

If workers face their own investment opportunity shocks, then workers would save but
only in money. See discussion of the later section.

5

ratio of the value of liquid money to illiquid equity of the private sector, andwill expand investment through a larger liquidity of investing entrepreneurs.8
Using this framework, we analyze how government (or central bank) can use
the open market operation to accommodate the e¤ects of the shock to the
productivity and how it can o¤set the e¤ects of shock to the liquidity.

2

The basic model without government

Consider an in…nite-horizon, discrete-time economy with four objects traded:a nondurable general output, labour, equity and …at money. Fiat money is
intrinsically useless, and is in …xed supply M in the basic model of thissection.
There are two populations of agents, entrepreneurs and workers, each withunit measure. Let us start with the entrepreneurs, who are the central actors
in the drama. At date t, a typical entrepreneur has expected discounted
utility1Xs tu(cs )(1)Et
s=t

of consumption path fct ; ct+1 ; ct+2 ; :::g, where u(c) = log c and 0 < < 1.
He has no labour endowment. All entrepreneurs have access to a constantreturns-to-scale technology for producing general output from capital andlabour. An entrepreneur holding kt capital at the start of period t can employ
lt labour to produce
yt = At (kt ) (lt )1(2)
general output, where 0 < < 1. Production is completed within the periodt, during which time capital depreciates to kt , 0 < < 1. We assume thatthe productivity parameter, At > 0 which is common to all entrepreneurs,
follows a stationary stochastic process. Given that each entrepreneur employs
labour at competitive market with the real wage rate wt , the gross pro…t is
proportional to the capital stock as:
yt

wt lt = rt kt ;(3)

where the gross pro…t per unit of capital rt depends upon productivity, aggregate capital stock and labour supply condition as will be seen shortly.
8

This idea can be traced back to Metzler (1951).

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The entrepreneur may also have an opportunity to produce new capitalstock. Speci…cally, at each date t, with probability he has access to a
constant-returns technology that produces it units of capital from it unitsof general output good. The arrival of such an investment opportunity is
independently distributed across entrepreneurs and through time, and is independent of aggregate shocks. Again, investment is completed within the
period t –although newly-produced capital does not become available as an
input to the production of general output until the following period t+1:
kt+1 = kt + it :(4)

We assume there is no insurance market against having an investment
opportunity.9 We also make a regularity assumption that the subjective
discount factor is larger than the fraction of capital left after production(one minus the depreciation rate):
Asssumption 1 :> :This mild restriction is not essential, but will make the distribution of capitaland asset holdings across of individual entrepreneurs well-behaved.
In order to …nance the cost of investment, the entrepreneur who has aninvestment opportunity can issue equity claim to the future returns from the
newly produced capital. Normalize one unit of equity at date t to be claim
to the future returns from the one unit of investment of date t: it pays rt+1
output at date t+1, rt+2 at date t+2, 2 rt+3 at date t+3, and so on.
We make two critical assumptions. First, we assume that the entrepreneur who produces new capital cannot precommit to work through the
lifetime even though he is needed to produce full output described by the
production function; thus an investing entrepreneur can pledge at mostfraction of future returns from his new capital. As he can issue new equity
only up to fraction of new capital, the parameter represents the tightness
9This assumption can be justi…ed in a variety of ways. For example, it may not be
possible to verify that someone has an investment opportunity; or veri…cation may takeso long that the opportunity has gone by the time the claim is paid out. A long-term
insurance contract based on self-reporting does not work here because the people are able
to trade assets covertly. Each of these justi…cations warrants formal modelling. But weare reasonably con…dent that even if partial insurance were possible our broad conclusions
would still hold. So rather than clutter up the model, we simply assume that no insurance
scheme is feasible.

7

of the borrowing constraint an investing entrepreneur faces.10 Because anentrepreneur who …nds an investment opportunity faces this borrowing constraint, he must …nance the cost of investment partly from selling his holdingof equity and money.
The second critical assumption is that entrepreneurs cannot sell theirequity holding as quickly as money. More speci…cally, before the investment
opportunity disappears, the investing entrepreneur can sell only t fractionof his equity holding within a period even though he can use all his money
holding. It is tantamount to a peculiar transaction cost per period: zerofor the …rst fraction t of equity sold, and then in…nite. We take t as an
exogenous parameter of liquidity of the equity, and call t as "resaleability
constraint". We consider that the aggregate productivity At and the liquidityof equity t jointly follow a stationary Markov process in the neighbourhoodof the constant unconditional mean (A; ). A shock to At is productivity
shock, and shock to t is considered as "liquidity shock".
In general, an entrepreneur has three kinds of asset in his portfolio:
money, equity of the other entrepreneur, and unmortgaged capital stock (afraction of own capital stock against which the entrepreneur has not issued
the equity: own capital stock minus own equity issued).
Balance sheetmoney
own equity issued
equity of others
own capital stock
net worth
It turns out to be di¢ cult to analyze the aggregate ‡uctuations of theeconomy with these three assets, because there is a rich dynamic interaction
between the distribution of assets and aggregate production. Thus, we makea simplifying assumption: at every period, an entrepreneur can remortgage
up to a fraction t fraction of his unmortgaged capital stock. Then, equityof the other entrepreneurs and unmortgaged capital stock become perfect
substitute as means of saving: both pays the same returns stream of rt+1 at
date t+1, rt+2 at date t+2, 2 rt+3 at date t+3, and so on per unit; and theholder can sell up to t fraction of his holding of both. Because equity held by
the agents other than the producer is sometimes called "outside equity" andunmortgaged capital stock is called "inside equity", we call both together as
10

See Hart and Moore (1994) which explains how the borrowing constraint arises frominalienability of human capital of the entrepreneur.

8"equity".
Let nt be the quantity of equity and let mt be money held by an individual
entrepreneurs at the start of period t. The liquidity constraints (borrowing
constraint and resaleability constraint) are expressed as
nt+1

(1

)it + (1mt+1t)

nt ; and

(5)
(6)

0:

The entrepreneur who invests it can issue at most it equity and can resell
at most t fraction of outside and inside equity holding after depreciation
during this period. Taken together, (5) implies the minimum holding ofequity at the beginning of period t+1 is equal to 1
fraction of investment
plus 1
t fraction of depreciated equity holding of this period. (6) implies
his …at money holding cannot be negative - the only agent who can have anegative position of …at money is government (or central bank) in the next
section.
Let qt be the price of equity in terms of general output. It is also equal to
Tobin’s q: the ratio of stock market value to the replacement cost of capital,(noting that production cost of capital is unity per unit). Let pt be the priceof money in terms of general output. (Warning! pt is customarily de…ned
as the inverse: the price of general output in terms of money. But, a priori,
money may not have value, so we prefer not to make it the numeraire.) The
entrepreneur’s ‡ow of funds constraint at date t is then given by
ct + it + qt (nt+1

itnt ) + pt (mt+1

m t ) = rt n t :(7)

The left-hand side (LHS) is his expenditure on consumption, investment
and net purchases of equity and money. The right-hand side (RHS) is his
dividend income, which is proportional to the holding of equity at the startof this period.
Turn now to the workers. At date t, a typical worker has expected discounted utility
1
X
!
1+
s t
(ls0 )
;
(8)
Et
U c0s
1
+
s=t

of consumption path fct ; ct+1 ; ct+2 ; ::g given his labour supply path flt ; lt+1 ; lt+2 ; ::g,where ! > 0; > 0 and U [ ] is increasing and strictly concave. The ‡ow-offunds constraint of the worker is
c0t + qt (n0t+1

n0t ) + pt (m0t+19m0t ) = wt lt0 + rt n0t :(9)

The consumption expenditure and net purchase of equity and money in the
LHS is …nanced by wage and dividend income. Workers do not have investment opportunities, and cannot borrow against their future labour income.
n0t+1

0; and m0t+1

0:

(10)

An equilibrium process of prices fpt ; qt ; wt g is such that: entrepreneurs
choose labour demand lt to maximize the gross pro…t (3) subject to production function (2) for a given start-of-period capital stock, and choose
consumption, investment, capital stock and start-of-next-period equity andmoney holdings fct ; it ; kt+1 ; nt+1 ; mt+1 g, to maximize (1) subject to (4) (7); workers choose consumption, labour supply, equity and money holding
c0t ; lt0 ; n0t+1 ; m0t+1 to maximize (8) subject to (9) and (10); and the markets
for general output, labour, equity and money all clear.
Before we characterize equilibrium, it helps to clear the decks a little bysuppressing reference to the workers. Given that their population has unit
measure, it follows from (8) and (9) that their aggregate labour supply equals(wt =!)1= . Maximizing the gross pro…t of a typical entrepreneur controlling
capital kt , we …nd his labour demand, kt [(1)At =wt ]1= which is proportional to kt . So if the aggregate stock of capital controlled by entrepreneurs
at the start of date t is Kt , labour-market clearing requires that(wt =!)1= = Kt [(1)At =wt ]1= :Substituting back the equilibrium wage wt into the LHS of (3), we …nd thatthe individual entrepreneur’s maximized gross pro…t equals rt kt where1

rt = at (Kt )and the parameters at and

(11)

;

are derived from At ; ; ! and :
1

at =
=

1

+

!
(1 + ):+

1+(At ) +

(12)

Note from (12) that lies between 0 and 1, so that rt –which is parametricfor the individual entrepreneur –declines with the aggregate stock of capital
Kt , because the wage increases with Kt . But for the entrepreneurial sector10as a whole, gross pro…t rt Kt increases with Kt . Also note from (12) thatrt is increasing in the productivity parameter At through at . Later we willshow that in the neighbourhood of the steady state monetary equilibrium,a worker will choose to hold neither equity nor money. That is, the worker
simply consumes his labour income at each date:c0t = wt lt0 :(13)

We are now in a position to characterize the equilibrium behaviour of theentrepreneurs. Consider an entrepreneur holding equity nt and money mt
at the start of date t. First, suppose he has an investment opportunity: letthis be denoted by a superscript i on his choice of consumption, and startof-next-period equity and money holdings, cit ; nit+1 ; mit+1 . He has two waysof acquiring equity nit+1 : either produce it at unit cost 1, or buy it in themarket at price qt . (See the LHS of the ‡ow-of-funds constraint (7), where,
recall, investment it corresponds to investment.) If qt is less than 1, the agent
will not invest. If qt equals 1, he will be indi¤erent. If qt is greater than 1,
he will invest by selling as much equity as he can subject to the constraint(5). The entrepreneur’s production choice is similar to Tobin’s q theory ofinvestment.
As the aggregate productivity and liquidity of equity (At ; t ) follow astochastic process in the neighbourhood of constant (A; ), we have the following claim in the neightbourhood of the steady state equilibrium (All the
proofs are in Appendix):
Claim 1 Suppose thatandsatisfy

Condition 1 : (1

) +

> (1

)(1

):

Then in the neighbourhood of the steady state:(i) the allocation of resource is the …rst best(ii) Tobin’s q is equal to unity: qt = 1;(iii) money has no value: pt = 0;(iv) the gross dividend is roughly equal to the time preference rate plus.
the depreciation rate: rt ' 1
If the investing entrepreneurs can issue new equity relatively freely andexisting equity is relatively liquid to satisfy Condition 1, then the equity market transfers enough resources from the savers to the investing entrepreneurs11to achieve the …rst best allocation.11 There would be no extra advantage of
having investment opportunity; Tobin’s q is equal to 1 (or the market valueof capital is equal to the replacement cost) and both investing entrepreneurs
and savers earn the same net rate of return on equity which is approximately
equal to the time preference rate. (Note that the usual risk premium would
be fairly negligible in the …rst best with our logarithmic utility function). Because the economy achieves the …rst best allocation without money, money
has no value in the equilibrium.
In the following we want to restrict attention to an equilibrium in which
qt is greater than 1. We also want money to have value in equilibrium. Let
us assume that and satisfy:
Assumption 2 : 0 < ( ; ), where
( ; )

2

+[(
[ (1

(1

)(1
)[(1
)(1
) (1
)(1
) + (1

)(1
) (1
)
] [1
) + ( +

)
+

]
(1

)

) ]:

Because both and are between 0 and 1, we observe all the terms in the
RHS are positive, except for the terms (1
)(1
) (1
)
and
(
)(1
) (1
)
. Thus a su¢ cient condition for Assumption
2 is
(1
) +
<(
)(1
);
and a necessary condition is
(1

) +

< (1

)(1

):

We observe that if the Condition 1 for Claim 1 is satis…ed, then the necessary
condition is not satis…ed and there would be no equilibrium with valued …atmoney. Under Assumption 2, however, upper bound on and is tightenough to ensure that the following claim holds.
11

In the steady state, the aggregate saving (which is equal to aggregate investment)
is equal to the depreciation of capital. The RHS of Condition 1 is equal to the ratio of
aggregate saving of non-investing entrepreneurs (who are 1
fraction of total entrepreneurs) to aggregate capital stock in the …rst best allocation. The LHS is the ratio of
maximum equity sold by the investing entrepreneurs to aggregate capital stock: (1)
corresponds to the new equity issued andcorresponds to the existing equity sold by
the investing entrepreneurs (which is fraction of total entrepreneurs). Thus Condition 1says that the maximum equity sold by the investing entrepreneurs is enough to shift theaggregate saving of the non-investing entrepreneurs.

12]Claim 2 Under Assumption 2, in the neighbourhood of the steady state:(i) the price of money, pt , is strictly positive;(ii) the price of capital, qt , is strictly greater than 1;(iii) an entrepreneur with an investment opportunity faces the binding
liquidity constraints and will not choose to hold money: mit+1 = 0.
We will be in a position to prove the claim once we have laid out theequilibrium conditions - we use a method of guess-and-verify in the following.
For values of and which do not satisfy Assumption 2 nor the condition
for Claim 1, we can show that money has no value even though the liquidity
constraint (5) still binds. To streamline the paper, we have chosen not togive an exhaustive account of the equilibria throughout the parameter space.
There is a caveat to Claim 2(i). Fiat money can only be valuable to someone if other people …nd it valuable, hence there is always a non-monetary
equilibrium in which the price of …at money is zero. Thus when there is amonetary equilibrium in addition to the non-monetary equilibrium, we restrict attention to the monetary equilibrium: pt > 0. Claim 2(iii) says thatthe entrepreneur prefers investment with the maximum leverage to holding
money, even though the return is in the form of equity which at date t+1
is less liquid than money. (Incidentally, even though the investing entrepreneurs don’t want to hold money for liquidity purposes, the non-investing
entrepreneurs do –see below. This is why Claim 2(i) holds.)
Thus, for an investing entrepreneur, the liquidity constraints (5) and (6)are both binding. His ‡ow of funds constraint (7) can be rewritten
cit + (1qt ) it = (rt +t qt ) n t + p t m t :(14)

In order to …nance investment cost it , the entrepreneur issues equity as muchas it at price qt . Thus the second term in the LHS is the investment cost thathas be be …nanced internally - the downpayment for investment. The LHS is
the total liquidity needs of the investing entrepreneur. The RHS corresponds
to the maximum liquidity supplied from dividend, sales of resaleable fractionof equity after depreciation and the value of money. When we solve this‡ow-of-funds constraint with respect to the equity of the next period, we
haveR
cit + qtR nit+1 = rt nt + [ t qt + (1t )qt ] nt + pt mt ;1
qt
< 1, as qt > 1:
where qtR
1

13

(15)
(16)

The value of qtR is the e¤ective replacement cost of equity to the investing
entrepreneur: because he needs downpayment 1
qt for every unit of investment in order to retain 1
inside equity, he needs (1qt )=(1) inorder to acquire one unit of inside equity. The RHS of (15) is his net worth:gross dividend, the value of his depreciated equity nt - of which resaleable t
fraction is valued by the market price and the non-resaleable 1
t fraction
is valued by the e¤ective replacement cost -, and the value of money.
Given the discounted logarithmic preferences (1), the entrepreneur saves
a fraction of his net worth, and consumes a fraction 1:12cit = (1) rt nt + [ t qt + (1Rt )qt ]

n t + pt mt :(17)

And so, from (14), we obtain an expression for his investment in period t:
it =

(rt +

t qt ) n t + p t m t

1

qt

cit

:

(18)

The investment is equal to the ratio of liquidity available after consumption
to the downpayment per unit of investment.
Next, suppose the entrepreneur does not have an investment opportunity:
denote this by a superscript s to stand for a pure saver. The ‡ow-of-funds
constraint (7) reduces to
cst + qt nst+1 + pt mst+1 = rt nt + qt nt + pt mt :(19)

For the moment, let us assume that constraints (5) and (6) do not bind.
Then the RHS of (19) corresponds to the entrepreneur’s net worth. It is thesame as the RHS of (15), except that now his depreciated equity is valued at
the market price, qt . From this net worth he consumes a fraction 1:
cst = (1)(rt nt + qt nt + pt mt ):(20)

Note that consumption of entrepreneur who does not have investment opportunity is larger than consumption of the investing entrepreneur if both
hold the same equity and money at the start of period. The remainder issplit across a savings portfolio of mt+1 and nt+1 .
12Compare (1) to a Cobb-Douglas utility function, where the expenditure share ofpresent consumption out of total wealth is constant and equal to 1= 1 + + 2 + ::: =1.

14

To determine the optimal portfolio, consider the choice of sacri…cing one
unit of consumption ct to purchase either 1=pt units of money or 1=qt unitsof equity, which are then used to augment consumption at date t+1. The…rst-order condition is
pt+1(1) u0 cst+1 + u0 (cit+1 )(21)
pt
rt+1 + qt+1 0 s
u ct+1
= (1
) Et
qt
(
)
R
rt+1 + t+1 qt+1 + 1
t+1 qt+1 0+ Et
u cit+1 :qt

u0 (ct ) = Et

The RHS of the …rst line of (21) is the expected gains from holding 1=pt
additional units of money at date t+1: money will always yields pt+1 which
will increase utility by u0 cst+1 times as much when he will not have an
investment opportunity with probability 1
and and will increase utility
0 iby u (ct+1 ) times as much when he will have an investment opportunity withprobability at date t+1. The second line is the gain in expected discounted
utility from holding 1=qt additional units of equity at date t+1. Per unit,
this additional equity yields rt+1 dividend, plus its depreciated value. With
probability 1
the entrepreneur will not have an investment opportunity
and the depreciated equity will be valued at the market price, qt+1 , and theseyields will increase utility by u0 cst+1 times as much. With probability theentrepreneur will have an investment opportunity at date t+1, in which casehe will value depreciated equity by the market price qt+1 for resaleable fracR
for non-resaleable fraction,
tion and by the e¤ective replacement cost qt+1
and these yield will increase utility by the marginal utility conditional on
investment u0 cit+1 . Because the e¤ective replacement cost is lower thanthe market price in monetary economy and the equity is only partially resaleable, the equity will have lower contingent return in the state in which
the entrepreneur needs fund most with an arrival of investment opportunity
and the marginal utility of consumption is high (as cit+1 < cst+1 ).
Equity is "risky" to the saving entrepreneur not only because the rateof return is correlated with aggregate consumption (aggregate risk) but also
because the contingent rate of return is low due to limited resaleability whenthe entrepreneur’s marginal utility is high (idiosyncratic risk). Money is"free" from idiosyncratic risk of having investment opportunity, because its
rate of return is independent of whether or not the entrepreneur has an15

investment opportunity in the next period.
We are now in a position to consider the aggregate economy. The great
merit of the expressions for an investing entrepreneur’s consumption andinvestment choices, cit and it , and a non-investing entrepreneurs’consumption
and savings choices, cst , nt+1 and mt+1 , is that they are all linear in start-ofperiod equity and money holdings nt and mt .13 Hence aggregation is easy: we
do not need to keep track of the distributions. Notice that, because workers
do not choose to save, the aggregate holdings of equity and money of theentrepreneurs are equal to aggregate capital stock Kt and money supply M .
Since investment opportunities are independently distributed, we can workwith the total capital and money holdings in the economy, Kt and M . At thestart of date t, a fraction of Kt and M is held by entrepreneurs who havean investment opportunity. From (18), total investment, It , in new capital
therefore satis…es(1qt ) It =[(rt +

t qt )Kt + pt M ]

(1

)(1

t)

qtR Kt : (22)Goods market clearing requires that total output (net of labour costs,
which equals the consumption of workers), rt Kt , equals investment plus
consumption of entrepreneurs–which, using (17) and (20), yields
rt Kt = at Kt = It + (1[rt + (1+)
t ) qt + (1

(23)
t)

qtR ]Kt + pt M:

It remains to …nd the aggregate counterpart to the portfolio equation(21). During period t, the investing entrepreneurs sell a fraction of theirinvestment It , together with a fraction t of their depreciated equity holdings
Kt , to the non-investing entrepreneurs. So the stock of equity held by thegroup of non-investing entrepreneurs at the end of the period is given bys
It + t Kt + (1) Kt Nt+1. And, by claim 2(iii), we know that thisgroup also hold all the money stock, M . We also know that the marginalutility of consumption is proportional to the inverse of consumption (thatis proportional to the net worth) due to logarithmic utility function. The
13

From (19) and (20), the value of savings, qt nst+1 + pt mst+1 is linear in nt and mt , and(the reciprocal of) the portfolio equation (21) is homogeneous in nnt+1 ; mnt+1 , noting thatu0 (c) = 1=c with logarithmic utility function:16sgroup’s savings portfolio (Nt+1, M ) satis…es (21), which can be simpli…ed to:

(1
=

Et

(rt+1 + qt+1 )=qt pt+1 =pt
s(rt+1 + qt+1 )Nt+1+ pt+1 MR
pt+1 =pt [rt+1 + t+1 qt+1 + (1t+1 ) qt+1 ]=qt:
sR
[rt+1 + t+1 qt+1 + (1t+1 ) qt+1 ]Nt+1 + pt+1 M
) Et

(24)

Equation (24) lies at the heart of the model. When there is no investment
opportunity at date t+1, so that the partial liquidity of equity doesn’t matter, the return on capital, (rt+1 + qt+1 )=qt exceeds the return on money,
pt+1 =pt : the LHS of (24) is positive. However, when there is an investment
opportunity, the contingent rate of return on equity, [rt+1 + t+1 qt+1 + (1R
t+1 ) qt+1 ]=qt is less than the return on money: the RHS of (24) is positive.
These return di¤erentials have to be weighted by the respective probabilities
and marginal utilities. The liquidity premium of equity over money in the
LHS can be substantial and time-varying, because the equity holder faces
the idiosyncratic cost of limited resaleability in the RHS in case of having an
investment opportunity (in addition to usual aggregate risk).14
Aside from the liquidity shock t and the technology parameter At which
follow an exogenous stationary Markov process, the only state variable inthis system is Kt , which evolves according toKt+1 = Kt + It :(25)

Restricting attention to stationary price process, the competitive equilibrium can be de…nes recursively as function (It ; pt ; qt ; Kt+1 ) of aggregate state(Kt ; At ; t ) that satisfy (11) ; (22) (25), together with the law of motionof At and t . From these four equations to characterize the equilibrium,
we observe that there are rich interaction between quantities (It ; Kt+1 ) and14

Holmstrom and Tirole (1998, 2001) develop models of three-period production economy with …nancial intermediaries in which pledgeable future returns are limited. One of
the main di¤erences from ours is that the liquidity needs of each individual entrepreneur
is contractible and that there is no constraint on resaleability. In Holmstrom and Tirole(2001), the liquidity premium of each asset depends upon the covariance between its rateof return and the aggregate liquidity needs. Because of limited insurance, our approachis perhaps closer to Luttmer (1996, 1999) which examine the implications of transaction
costs and short-sales constraints for consumption and asset prices.
Atkeson and Kehoe (2008) argue for the need for the time-varying risk premium toanalyzing monetary policy.

17

asset prices (pt ; qt ). In this sense, our economy is similar to Keynes (1936).
In fact, perhaps the closest ancestor of our model is Tobin (1969) where heconsiders Tobin’s q as the key variable to analyze the interaction between
goods market and asset market. From methodological point of view, ourmodel is similar to more modern macroeconomics because we derive all the
behavioral relationship from individual optimization under the constraints oftechnology and liquidity.
In steady state, when at = a (the RHS of (12) with At = A) and t = ,capital stock K, investment I, and prices p and q, satisfy I = (1)K and
aK

1

+

pM
= 1
K

aK

1

(1

+

)

pM
K

1
1

(1

1

+

(1

+(1

) 1

(1

=

)

q)

)
1
1

q

1
1

(26)

(27)
q

q + (pM= K);
aK 1 ++ 1 q + (pM= K)
(28)
where
(1
) + (1+ ) ; the steady-state fraction of equity heldby non-investing entrepreneurs at the end of a period.
Equations (26), (27) and (28) can be viewed as a simultaneous systemin three unknowns: the price of capital, q; the gross pro…t rate on capital,r = aK 1 ; and the value of the money stock as a fraction of total capital,
pM=K. (26) and (27) can be solved for a aK 1 and pM=K, each as a¢ nefunctions of q, which when substituted into (28) yield a quadratic equationin q with a unique positive solution. Assumption 2 is su¢ cient to ensure that
this solution lies strictly above 1 (but below 1= ). We can also show that
Assumption 2 is the necessary and su¢ cient condition for money to havevalue: p > 0.
As a prelude to the dynamic analysis that we undertake later on, noticethat the technology parameter A only a¤ects the steady-state system throughthe gross pro…t term aK 1 . That is, a rise in the steady state value of A
increases the capital stock, K, but does not a¤ect q, the price of capital. The
price of money, p, increases to leave pM=K unchanged.
aK

1

(1

)q =

1
1

(q

1)

18

1
1

It is interesting to compare our economy, in which the liquidity constraints(5) and (6) bind for investing entrepreneurs, to a "…rst-best" economy without such constraints. Consider steady states. In the …rst-best economy, theprice of capital would equal its cost, 1; and the capital stock, K say, would
equate the return on capital, aK 1 + , to the agents’common subjective
return, 1= . (See Claim 1). We can show that, in our constrained economy,
the level of activity –measured by the capital stock K –is strictly below K .
Hence, by continuity, the same is true in the neighbourhood of the steadystate. Because of the partial liquidity of equity, the economy fails to transfer
enough resources to the investing entrepreneurs to achieve the …rst-best levelof investment.
The liquidity constraint creates the wedges between the marginal productof capital and the expected rate of returns on equity, and turns out to keep
both the expected rates of return on equity and that of money below thetime preference in the neighborhood of the steady state. Intuitively, the rateof returns on assets to savers are below their time preference rate so that thesavers will not save enough to escape the liquidity constraint when they …nd
an opportunity to invest in future.
Claim 3 In the neighbourhood of the steady state monetary economy,(i) the stock of capital, Kt+1 is less than in the …rst-best (unconstrained)
economy:1
Kt+1 < K , Et at+1 Kt+11 +> ;(ii) the expected rate of return on equity (if the saver does not have investment opportunity at date t+1) is lower the time preference rate:
Et

at+1 Kt+11 + qt+1
1
< ;
qt

(iii) the expected rate of return on money is lower than the expected rateof return on equity:Et

at+1 Kt+11 + qt+1
pt+1
< Et
;
pt
qt

(iv) the expected rate of return on equity contingent on having an investment opportunity in the next period is lower than the expected rate of return19

on money:Et

at+1 Kt+11 +t+1

qt+1 + (1
qt

t+1 )

R
qt+1

<

pt+1
:
pt

Claim 3(iii) follows directly from (28), given that in steady state q > 1.
This di¤erence between the expected return on equity and money re‡ects aliquidity premium. It equals the nominal interest rate on equity.15 Because
entrepreneurs are constrained when they have an investment opportunity,
they have to be compensated for holding less liquid equity in their savings
portfolio. If there were no binding liquidity constraints, money would haveno value.
In our monetary economy, there are a spectrum of interest rates: fromthe highest, we have the expected marginal product of capital, the time
preference rate, the expected rate of return on equity, the expected rateof return on money, and the expected rate of return on equity contingent
on the saver having an investment opportunity in the next period. These
spreads across di¤erent interest rates come from the very feature of monetary
economy in which the circulation of money is essential for resource allocation.
Thus in our economy the impact of the asset markets on aggregate production
cannot be summarized by the expectations of a single real interest rate frompresent to future as in some popular models such as Woodford (2003). It
is equally misleading to use the average real rates of returns on money andequity for the time preference rate to calibrate our economy.
The fact that the expected rates of return on equity and money are both
lower than the time preference rate justi…es our earlier assertion that workers
will not choose to save by holding capital or money.16 (Of course, if workers
could borrow against their future labour income they would do so. But we
15

By the Fisher equation, the nominal interest rate on equity equals the net real returnon equity plus the in‡ation rate. But minus the in‡ation rate equals the net real return on
money. Hence the nominal interest rate on equity equals the real return on equity minus
the return on money, i.e. the liquidity premium. Because our money is broad money asset readily resaleable, our nominal interest rate is similar to the interest rate in Keynes(1936); the gap between the rate of return on partially resaleable assets and broad money.
16
Workers would save if workers were to face their own investment opportunity shocks.
Suppose, instead, that each worker randomly meets a "health shock" with which the worker
has to spend immediately some …xed amount of co-payment in order to maintain hishuman capital. (The health insurance covers some costs, but the patient has to cover theco-payment from his own pocket here). Then, if the resaleability of equity is low, we canshow that worker save only in money up to the value enough to cover the co-payment .

20

have ruled this out.) In steady state, workers enjoy a constant consumption
equal to their wages.
The reason why an entrepreneur saves, and workers do not, is because
the entrepreneur is preparing for his next investment opportunity. And theentrepreneur saves using money as well as equity, despite money’s particularly
low return, because he anticipates that he will be liquidity constrained at
the time of investment. Along a typical time path, he experiences episodes
without investment, during which he consumes part of his saving. As thereturn on saving –on both capital and money –is less than his time preference
rate, the value of his net worth gradually shrinks, as does his consumption.
He only expands again at the time of investment. In the aggregate picture,
we do not see all this …ne grain. But it is important to realize that, even insteady state, the economy is made up of a myriad of such individual histories.

3

Dynamics

In order to examine the dynamics of our economy, we can use the recursive
equilibrium - function (It ; pt ; qt ; Kt+1 ) of aggregate state (Kt ; At ; t ) that satisfy (11) and (22) (25), together with the law of motion of (At ; t ).
To start with, let’s look at how the economy ‡uctuates with deterministic shifts of aggregate productivity, like seasonal cycle.17 Suppose that theaggregate productivity alternate between high level and low level for every
T > 1 periods deterministically. We take the length of one period very shortin order to examine the dynamics. (In Appendix, we layout the continuous
time limit of our economy). F igure 1 shows how asset prices and quantities‡uctuate with the deterministic shifts of aggregate productivity.
Because the timing of the productivity shifts is known in advance, there isno discontinuous jump in the nominal price of equity qt =pt at the time of productivity shift. (If the nominal price of equity jumped, say jumped up, thensaving entrepreneurs would have held only equity immediately before theEven though the rate of return on equity is higher than money, the worker would require
to save more in equity than money in order to compensate the resaleability constraint,
which would be more costly, given that the rate of return on equity is lower than the time
preference rate. See Kiyotaki and Moore (2005a) for the detail.
17
Barsky and Miron (1989) and Miron (1996) document that there are many similarities
between seasonal cycle and business cycle in terms of relative volatility and co-movementof aggregate prices and quantities. Thus, we may learn about the property of our economy
by examining how the economy ‡uctuates with the deterministic cycle of the productivity.

21

22

jump). From the goods market equilibrium condition, (23), we observe thereal asset prices (pt ; qt ) in terms of general output have to increase together
at the time of productivity increase in order to increase the consumption andinvestment in line with a larger output supply. Although investment is moresensitive to the asset prices and thus increases more than consumption in
proportion, consumption also jumps up as the net worth increases. This isdi¤erent from the …rst best allocation, in which consumption of the entrepreneurs does not jump against the deterministic shift of the productivity.18
After the productivity improvement, the real asset prices, investment andconsumption continue to increase with capital accumulation, until productivity switch from a high to a low level.
Now, let’s consider liquidity shocks: a stochastic shock to the resaleabilityof equity, t . Suppose that t follows a Markov process with two states,(1 + ) and (1) and constant arrival rateof switch every period,
where
and
are small positive parameters. F igure 2 shows the processof the asset prices and quantities with a particular realization of the stochastic
process of the liquidity t .
When the resaleability of equity falls to a low level persistently with astochastic arrival of the switch, then the investing entrepreneurs can …nanceonly a smaller downpayment from selling his equity holding. Also the entrepreneurs without investment opportunity …nd equity less attractive thanmoney as means of saving (if the expected rate of returns were unchanged),because he can resale only a smaller fraction of equity holding if he has aninvestment opportunity in the following period and he has to revalue thenon-resaleable fraction of equity by the e¤ective replacement costs (which islower than the market price). (See (24)). Thus, the equity price falls andthe value of money increases in order to restore the asset market equilibrium.
This can be thought of "a ‡ight to liquidity". Because of the lower equity
price, the investing entrepreneur needs more downpayment per unit of investment. Taken together, aggregate investment decreases substantially, despitethat the increase of value of money partially o¤sets the decrease. (See (22)).
Because output is not a¤ected with full employment, consumption increases
to restore goods market equilibrium. Overtime, capital decumulates withlower investment, and the real asset prices, investment and consumption all
18
Consumption of workers jumps with the deterministic productivity shift, because themarginal utility of consumption is a¤ected by labour supply (and labour supply depends
upon productivity).

23

24

decrease, until the resaleability of equity switches from a low to a high level.

4

Introducing government

Our goal here is simply to explore the e¤ects on equilibrium of an exogenous
government policy. We make no attempt to explain government behaviour.
At the start of date t, suppose the government holds Ntg equity. Unlike
entrepreneurs, the government cannot produce new capital. However, it canengage in open market operations, to buy (sell) equity by issuing (taking in)money –it has sole access to a costless money-printing technology.19 Finally,
the government can purchase goods, or transfer to the workers (which can be
negative if it is lump-sum tax). Let Gt denote the total government purchaseof general output and real lump-sum net transfer to workers. We assume
Gt does not a¤ect utility of entrepreneurs. This leaves intact our analysis ofentrepreneurs’behaviour. We assume that Ntg and Gt are not so large thatthe private economy switches regimes. That is, we are still in an equilibrium
in which the liquidity constraints bind for investing entrepreneurs, and money
is valuable.
If Mt is the stock of money privately held by entrepreneurs at the startof date t, then the government’s ‡ow-of-funds constraint is given byg
Gt + qt Nt+1

Ntg = rt Ntg + pt (Mt+1

(29)

Mt ):

That is, government net purchase of general output and equity must equal
dividend of equity plus seigniorage revenues. Since the government is a large
agent, at least relative to each of the atomless private citizens, open market
operations will a¤ect the prices pt and qt .
All of our earlier analysis goes through, but with obvious adjustments.
Total supply of equity (which is equal to aggregate capital stock by the wayof de…ning the equity) is equal to the sum of the government holding andaggregate holding of the entrepreneurs (denoted as Nt )Kt = Ntg + Nt :(30)

The tax changes workers’consumption (as they consume all the disposable
income), but, given the form of their preferences in (8), does not a¤ect their
19g
Any sales of equity are subject to the same constraint as (5): Nt+1

25

(1

t)

Ntg .

labour supply. Equations (22) ; (23) and (24) are modi…ed to:(1qt ) It =[(rt +

t qt )Nt + pt Mt ](1)
rt Kt = at Kt = It + Gt + (1[rt + (1+ t ) qt + (1
(1
= Et

) Et

)(1

t)

qtR Nt

(31)
(32)

t)

qtR ]Nt + pt Mt(rt+1 + qt+1 )=qt pt+1 =pts+ pt+1 Mt+1
(rt+1 + qt+1 )Nt+1(33)

R
pt+1 =pt [rt+1 + t+1 qt+1 + (1t+1 ) qt+1 ]=qt;
Rs[rt+1 + t+1 qt+1 + (1t+1 ) qt+1 ]Nt+1 + pt+1 Mt+1gs
= It + t Nt + (1) Nt + Ntg Nt+1
. Suppose we take bothwhere Nt+1g
the policy variables Gt ; Nt+1 ; Mt+1 and the parameters of technology andliquidity (At ; t ) to follow exogenous stationary Markov processes. Then,
restricting attention to stable price process, the competitive equilibrium canbe de…ned recursively as functions (It ; pt ; qt ; Nt+1 ; Kt+1 ) of the aggregate state(Nt ; Kt ; Mt ; At ; t ; Ntg ) that satisfy (11),(25),(29) (33) together with theglaws of motion of At ; t ; Gt ; Nt+1
; Mt+1 .20
How should the central bank use the open market operation against thedeterministic shifts of productivity (as in F igure 1)? The problem of laissezfaire monetary economy is that consumption is not smooth even if the productivity shift is deterministic. Thus, the central bank can conduct the
open market purchase operation of equity immediately before the upward
productivity shift. As the central bank purchase equity with money, the private entrepreneurs hold a larger amount of liquid money and hold a smaller
amount of partially resaleable equity, and thus the entrepreneurs can investment more. From the RHS of (31), precisely because the equity is less liquidthan money t < 1, we see investment will increase if the value of money
increase as much as the decrease of the value of private holdings of equity by
the open market operation:p t Mt =qt Nt > 0:(34)

If the size of the open market operation is such that investment and out20

If there were lump-sum transfer of money to the entrepreneurs (helicopter drop), thenthe aggregate quantities do not change in our economy because the prices are ‡exible. The
consumption and investment of the individual entrepreneur, however, is a¤ected by thehelicopter drop, because there is redistribution from rich to poor entrepreneurs throughlump-sum money transfer and in‡ation.

26

27

put increase by equal amount with the productivity improvement, then the
consumption is perfectly smooth at the time of deterministic productivity
shift. In other words, the central bank can use the open market operation toaccommodate the productivity shifts in order to smooth consumption. See
F igure 3.
When the resaleability of equity ‡uctuates stochastically and the productivity is unchanged as in F igure 2, then the central bank can use the open
market operation in order to o¤set the e¤ect of the liquidity shock. When theresaleability of equity falls with an arrival of the liquidity shock, the central
bank can do the open market purchase operation to increase the liquidity of
the investing entrepreneurs as in (34). Then the quantities and asset prices
will be insulated from the liquidity shock.21 See F igure 4.
Here the open market operation must be to purchase the asset whichhas partial resaleability and a substantial liquidity premium. If the liquidity
premium of the short-term government bond is very low (as in Japan fromthe late 1990s to the 2000s), then the traditional open market operation onlychanges the composition of broad money and has limited e¤ects. The recent
unorthodox policy of the Federal Reserve Bank and the Bank of England,such as Term Security Lending Facility, is an attempt of increasing the liquidity by supplying more treasury bills against partially resaleable securities,
such as mortgage backed securities. Perhaps one of the main reasons that
the Fed lends treasury bills instead of selling treasury bills in exchange ofmortgage backed securities is that the Fed concerns about the adverse selection problem in the mortgage backed securities that the current holders may
have better information about the quality. (See footnote 4 and the reference
within).
In order to analyze the e¤ect of the open market operation over thebusiness cycles, we assume that the government and central bank can precommit to conduct a particular policy. If we were to extend our analysis
to explain monetary and …scal policy in the long-run, including policy toincrease the return to money holders (such as Friedman’s rule or paying
a higher interest on broad money), then perhaps we have to explain why
government may be able to commit more than private agents. Also we haveto take into account how government enforces people to pay tax and how the21
This is true only approximately. After open market purchase of equity, the government
earns extra dividend income, which is spent on government purchse of general output in(29). Thus investment decreases a little to clear the goods market .

28

29

enforcement of taxation may crowd out people’s pledgeable future returns to
the other people.22
22

A related question would be: If government has a superior power to enforce people topay, why not government directly …nances people’s liquidity needs?

30

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32