Liquidity, Contagion and Financial Crisis1

In this paper we study the link between liquidity, firms’ access to external finance, and the real economy. We show that there is a feedback mechanism from collateral requirements to the fire-sale price of capital goods. As a result, an “abnormality” appears whereby supply and demand for liquidity both slope in the same direction. This generates a “multiplier” that amplifies the effect of external shocks. Hence, a shock can become contagious and propel the economy into a financial crisis, whereby collateral is sold off below fundamental value and some companies become credit rationed. For intermediate levels of the shock, muliple equilibria appear where the government can costlessly implement policies to coordinate expectations away from dominated equilibria. For high levels of the shock, financial crisis is the unique equilibrium. The competitive-equilibrium probability of a financial crisis is strictly positive. Stabilization policies that inject liquidity or bailout companies may decrease the probability of a crisis and enhance welfare, but will have fiscal implications. We structure the model so that its key parameters have a simple corporate-finance interpretation. We use numerical examples to show that the model’s quantitative fit is surprisingly good. Perhaps the most important implication of these numerical examples is that the ex-ante welfare effect of the stabilizing policies is very small.