Understanding liquidity shortages during severe economic downturns
One feature of economic recessions is the appearance of aggregate liquidity shortages that can exacerbate the economic downturn. We develop a model in which the demand for liquidity arises suddenly in response to continued funding needs of partially completed investment projects whose outcomes are subject to idiosyncratic shocks and moral hazard. When the economy experiences an adverse aggregate productivity shock, incentive constraints that underlie equity contracts may bind, provided the shock is severe enough. In this case, credit-rationing appears, and the heightened demand for liquidity coincides with a greater reluctance to take on equity positions or deepen investments in on-going investment projects. The consequence is a reduction in new investment and termination of on-going projects due to a lack of liquidity, thereby worsening the economic slowdown.
Year of publication: |
2011
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Authors: | Atolia, Manoj ; Einarsson, Tor ; Marquis, Milton |
Published in: |
Journal of Economic Dynamics and Control. - Elsevier, ISSN 0165-1889. - Vol. 35.2011, 3, p. 330-343
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Publisher: |
Elsevier |
Keywords: | Credit-rationing Moral hazard Occasionally binding constraints |
Saved in:
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