Liquidity and trading dynamics
By: Veronica Guerrieri, Guido Lorenzoni.
Contributors: Lorenzoni, Guido.; National Bureau of Economic Research.
Series: NBER working paper series -- no. 13204.; Working paper series (National Bureau of Economic Research) -- working paper no. 13204.
Publisher: National Bureau of Economic Research
Published: 2007
Place of publication: Cambridge, Mass
Language: eng
Number of pages: 46
Subjects: Liquidity (Economics); Econometric models
Description: 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.
Notes: "June 2007"

Includes bibliographical references (p. 44-46).

Also available in PDF from the NBER world wide web site (www.nber.org).