Working Paper: NBER ID: w13204
Authors: Veronica Guerrieri; Guido Lorenzoni
Abstract: 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.
Keywords: financial frictions; liquidity constraints; aggregate shocks; economic activity
JEL Codes: D83; E41; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| scarce liquidity (E44) | larger responses to aggregate shocks (E19) |
| self-insurance motive (G52) | consumption decisions sensitivity to expected income (D12) |
| scarce liquidity (E44) | consumption decisions sensitivity to expected income (D12) |
| larger responses to aggregate shocks (E19) | larger aggregate effects from shocks (E19) |
| abundant liquidity (E41) | smaller responses to aggregate shocks (E19) |
| abundant liquidity (E41) | less sensitivity of consumption decisions to income uncertainty (D11) |
| presence of liquidity constraints (D10) | magnifies output response to shocks (E13) |
| coordination problem in trading decisions (D70) | amplifies effects of aggregate shocks in scarce liquidity regime (E44) |