Liquidity, Asset Price and Banking

We consider an economy where people have the needs for liquidity because of the unanticipated consumption opportunity, yet banks may not provide su¢ cient liquidity due to imperfect technology in commitment, enforcement and record-keeping. We show a link between the liquidity generated by bank lending, the value of the asset used as collateral and aggregate economic activity. When the record-keeping is extremely limited so banks can only posses the collateral once defaults occur, higher in‡ation exerts adverse e¤ects on aggregate output because it reduces the value of the asset and the loan-to-value ratio. When the record-keeping is superior so that banks can exclude defaulters from the banking sector besides seizing the collated, higher in‡ation reduces the value of the asset, but raises the value of money, the loan-to-value ratio, and aggregate output. The reason is that in‡ation raises the cost of being excluded from the banking system and, thus, relaxes the borrowing constraint and increases liquidity to the aggregate economy. JEL Classi…cation: E41; E50