Liquidity, infinite horizons and macroeconomic fluctuations

This paper develops a computable dynamic general equilibrium model in which corporate demand for liquidity is endogenously determined. In the model, liquidity demand is motivated by moral hazard, as in Holmström and Tirole (J. Politic. Econom. 106 (1998) 1). As a result of incorporating agency cost and endogenously determined liquidity demand, the model can replicate an empirical business cycle fact, the hump-shaped dynamic response of output, which is seldom observed in standard RBC dynamics. Further, in the model the corporate demand for liquidity from a financial intermediary (credit line, for instance) is pro-cyclical, while the degree of liquidity dependence (defined as liquidity demand divided by corporate investment) is counter-cyclical. These business cycle patterns are consistent with a stylized fact empirically verified in the lending view literature.