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Understanding liquidity shortages during severe economic downturns

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  • Atolia, Manoj
  • Einarsson, Tor
  • Marquis, Milton

Abstract

One feature of economic recessions is the appearance of aggregate liquidity shortages that can exacerbate the economic downturn. We develop a model in which the demand for liquidity arises suddenly in response to continued funding needs of partially completed investment projects whose outcomes are subject to idiosyncratic shocks and moral hazard. When the economy experiences an adverse aggregate productivity shock, incentive constraints that underlie equity contracts may bind, provided the shock is severe enough. In this case, credit-rationing appears, and the heightened demand for liquidity coincides with a greater reluctance to take on equity positions or deepen investments in on-going investment projects. The consequence is a reduction in new investment and termination of on-going projects due to a lack of liquidity, thereby worsening the economic slowdown.

Suggested Citation

  • Atolia, Manoj & Einarsson, Tor & Marquis, Milton, 2011. "Understanding liquidity shortages during severe economic downturns," Journal of Economic Dynamics and Control, Elsevier, vol. 35(3), pages 330-343, March.
    • Handle: RePEc:eee:dyncon:v:35:y:2011:i:3:p:330-343
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    Cited by:

    1. Manoj Atolia & John Gibson & Milton Marquis, 2019. "Moral Hazard in Lending and Labor Market Volatility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 51(1), pages 79-109, February.
    2. Atolia, Manoj & Gibson, John & Marquis, Milton, 2018. "Asymmetry And The Amplitude Of Business Cycle Fluctuations: A Quantitative Investigation Of The Role Of Financial Frictions," Macroeconomic Dynamics, Cambridge University Press, vol. 22(2), pages 279-306, March.
    3. Pan, Li (Sunny) & Pezzuti, Todd & Lu, Wei & Pechmann, Cornelia (Connie), 2019. "Hyperopia and frugality: Different motivational drivers and yet similar effects on consumer spending," Journal of Business Research, Elsevier, vol. 95(C), pages 347-356.

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