Working Paper: CEPR ID: DP8511
Authors: John Driffill; Marcus Miller
Abstract: How and why do financial conditions matter for real outcomes? The ?workhorse model of money and liquidity? of Kiyotaki and Moore (2008) shows how--with full employment maintained by flexible prices--shifting credit constraints can affect investment and future aggregate supply. We show that, when the flex-price assumption is dropped, an adverse but temporary liquidity shock can rapidly lead to Keynesian-style demand failure. Optimistic expectations may speed recovery, but simulation results suggest that prompt liquidity infusion by the central bank--i.e. Quantitative Easing--is needed to check prolonged recession.
Keywords: Credit constraints; Liquidity shocks; Temporary equilibrium
JEL Codes: B22; E12; E20; E30; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| credit constraints (E51) | investment (G31) |
| credit constraints (E51) | future aggregate supply (Q11) |
| adverse liquidity shock (E44) | contraction in output (E23) |
| liquidity shock (E44) | investment (G31) |
| liquidity shock (E44) | consumption (E21) |
| liquidity infusion by central bank (E52) | avert prolonged recession (E65) |
| liquidity shock (E44) | output collapse (E23) |