Funding Liquidity and Market Liquidity

Recent empirical studies have shown an increasing co-movement between fund and market liquidity, which is driven by common factors such as monetary shocks. Modeling this co-movement becomes desirable to evaluate policies relating to liquidity and financial instability. This paper establishes a monetary model with capital to explain the dynamic interactions between funding and market liquidity in a search framework featured by Kiyotaki and Wright [1989]. Capital and money are two important elements here. As the collateral and production input, capital affects both fund and goods trading market. As medium of exchange, money is essential to trade; meanwhile the opportunity cost of carrying it affects the fund market imbalance as well. As a result, monetary policy can change traders' expectations and negotiations, and have non-trivial impact on fund markets and liquidity risks. Calibrated the model, simulated liquidity moments respond to monetary shocks, moving together across time and presenting business cycle properties.