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.