Search, Asset Liquidity and Business Cycles

This paper presents a real business cycle model with search frictions in the asset market, where equity liquidity is endogenously determined. I use the model to study how labor input, asset liquidity and asset prices fluctuate in response to productivity and liquidity shocks, and how, in turn, these fluctuations magnify the impact of productivity shocks on economic activity. A household’s investment is restricted by its holdings of liquid assets in the model. When a negative productivity shock hits the economy, entry into the asset market declines. This effect discourages investment because of the reduced liquidity of assets, thereby amplifying the decrease in total output. After calibrating the model to match key features of the U.S. data, I find that productivity and liquidity shocks are equally important in explaining business cycles, which is contrary to findings in some recent studies. In addition, I show that productivity shocks can generate pro-cyclical movements of labor input, asset prices and liquidity, which is not the case for liquidity shocks. The model also generates significant positive correlations between productivity and output,between productivity and labor input and between productivity and asset liquidity, in agreement with my empirical observations. JEL classification: E32, G12, G1