Liquidity, assets and business cycles

• The dynamic model incorporates frictions in both equity and debt financing.
• Financial shocks are shown to generate positive comovement among macro quantities.
• A negative shock to asset liquidity generates a counterfactual equity price boom.
• A negative shock to firms׳ collateral constraints also generates an equity price boom.
• Possible resolutions to this puzzle involve concurrent productivity shocks.

The objective here is to evaluate the quantitative importance of financial frictions in business cycles. The analysis shows that a negative financial shock can cause aggregate investment, employment and consumption to fall with output. Despite this realistic comovement among macro quantities, a negative financial shock generates an equity price boom as the shock tightens firms׳ financing constraint. This counterfactual response of the equity price is robust to a wide range of variations in how financial frictions are modeled and whether financial shocks affect asset liquidity or firms׳ collateral constraints. Some possible resolutions to this puzzle are discussed.