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Liquidity choice and misallocation of credit

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  • Ebrahimy, Ehsan

Abstract

This paper studies a novel type of misallocation of credit between investments of varying liquidity. One type of investment is more liquid, i.e., its return is more pledgeable, and the other is more productive. Low liquidities of both types imply that the allocation of credit is constrained inefficient and that there is overinvestment in the liquid type. Constrained inefficient equilibria feature too high interest rate, too much investment and too little consumption. Financial development reduces long-term welfare and output in a constrained inefficient equilibrium if it raises the liquidity of the liquid type. A debt tax can achieve constrained efficiency.

Suggested Citation

  • Ebrahimy, Ehsan, 2022. "Liquidity choice and misallocation of credit," European Economic Review, Elsevier, vol. 142(C).
    • Handle: RePEc:eee:eecrev:v:142:y:2022:i:c:s0014292121002877
    DOI: 10.1016/j.euroecorev.2021.104021
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