Liquidity and Trading Dynamics / Veronica Guerrieri, Guido Lorenzoni.

Format:

Book

Author/Creator:

Guerrieri, Veronica.

Contributor:

National Bureau of Economic Research.

Lorenzoni, Guido.

Series:

Working Paper Series (National Bureau of Economic Research) no. w13204.

NBER working paper series no. w13204

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2007.

Summary:

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:

Print version record

June 2007.