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We develop a search-theory of asset liquidity which gives rise to endogenous financing constraints on investment in an otherwise standard dynamic general equilibrium model. Asset liquidity describes the ease of issuance and resaleability of private financial claims, which is the outcome of a costly search-and-matching process for such claims implemented by financial intermediaries. Limited liquidity of private claims creates a role for liquid assets, such as government bonds, to ease financing constraints. We show that endogenising liquidity is essential to generate positive co-movement between asset liquidity and asset prices. When the cost of intermediating funds to entrepreneurs rises, investment and output fall whereas the hedging value of liquid assets increases, driving up liquidity premia. In the United States, such intermediation cost shocks can account for at least 37% of the variation in output, and more than 78% of the variation in liquidity premia.

We endogenize asset liquidity in a dynamic general equilibrium model with search frictions on asset markets. In the model, asset liquidity is tantamount to the ease of issuance and resaleability of private financial claims, which is driven by investors' participation on the search market. Limited resaleability of private claims creates a role for liquid assets, such as government bonds or fiat money, to ease funding constraints. We show that liquidity and asset prices positively co-move. When the capacity of the asset market to channel funds to entrepreneurs deteriorates, the hedging value of liquid assets increases. Our model is thus able to match the flight to liquidity observed during recessions. Finally, we show that investors' search market participation is more intense in a constrained efficient economy.

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. www.econstor.eu Terms of use: Documents in EconStor may WO R K I N G PA P E R S E R I E S N O 17 29 / S E P T E M B E R 2014 FLIGHT TO LIQUIDITY AND THE GREAT RECESSION Sören RaddeIn 2014 all ECB publications feature a motif taken from the €20 banknote.NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily refl ect those of the ECB. AbstractThis paper argues that counter-cyclical liquidity hoarding by nancial intermediaries may strongly amplify business cycles. It develops a dynamic stochastic general equilibrium model in which banks operate subject to agency problems and funding liquidity risk in their intermediation activity. Importantly, the amount of liquidity reserves held in the nancial sector is determined endogenously: Balance sheet constraints force banks to trade o insurance against funding outows with loan scale. A nancial crisis, simulated as an abrupt decline in the collateral value of bank assets, triggers a ight to liquidity, which strongly amplies the initial shock and induces credit crunch dynamics sharing key features with the Great Recession. The paper thus develops a new balance sheet channel of shock transmission that works through the composition of banks' asset portfolios.Keywords: macro-nance; funding liquidity risk; liquidity hoarding; bank capital channel; credit crunch. JEL classication: E22; E32; E44.ECB Working Paper 1729, September 2014 1 Non-technical summaryThe recent nancial crises and ensuing recessions in the United States and the euro area have highlighted the central role of nancial intermediaries in the transmission and amplication of nancial sector shocks to the real economy. A pronounced maturity mismatch between funding and assets exposed banks to roll-over risk in their renancing operations. This risk materialised as collateral pools used on markets for secured short-term renancing dried up and counter-party risk was perceived to rise. Banks responded by eeing into liquid assets, eventually crowding out lending to the non-nancial sector, thus transmitting nancial sector stress to the real economy.While the nance literature has long recognised funding liquidity risk and precautionary liquidity hoarding as important nancial sector vulnerabilities, the macroeconomic eects of a broadbased ight to liquidity in the banking sector have not been explicitly explored. In this paper, Istudy the trade-o ...