Quantitative Implications of Liquidity Constraints for Asset Prices and Monetary Policy

This paper investigates quantitative significance of liquidity constraints for asset prices and monetary policy in a monetary economy version of Kiyotaki and Moore (2005). Motivated by the lack of commitment in the intertemporal asset trade, the model economy features limited resalability of illiquid asset (e.g., physical capital) as well as a borrowing limit to which the illiquid asset can be pledged as collateral. The demand for money arises from the anticipation of future liquidity needs for random investment opportunities. The key parameter governing the degree of liquidity haircut is calibrated using the historical recovery rates and the rating agencies' advance rates criteria for bonds and loans, whereas the arrival rate of an investment opportunity is estimated using the simulated method of moments (SMM). The implied liquidity premium is countercyclical, which is consistent with the so-called 'flight to quality' during recessions or financial crises. The magnitude of the liquidity premium also accounts for a significant portion of the equity premium. Further, an open market monetary expansion in the model economy causes nominal interest rates to fall in the short term and rise back to normal levels over time. These persistent liquidity effects are driven by the liquidity constraints, together with a limited participation (or market segmentation) in investment opportunities which essentially brings about asymmetric distributional effects of monetary policy