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Liquidity and Investment in General Equilibrium

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Abstract

This paper studies how trading frictions in financial markets impact firms’ investment and dividend policies, and explores its aggregate consequences. When equity shares trade in frictional asset markets, the firm’s problem is time-inconsistent, and it is as if it faces quasi-hyperbolic discounting. The transmission of trading frictions to the real economy crucially depends on the firms’ ability to commit. In a calibrated economy without commitment, larger trading frictions imply lower capital. In contrast, if firms can commit, trading frictions affect asset prices but have little effect on aggregate capital. Our findings rationalize several empirical regularities on liquidity and investment.

Suggested Citation

  • Nicolas Caramp & Julian Kozlowski & Keisuke Teeple, 2022. "Liquidity and Investment in General Equilibrium," Working Papers 2022-022, Federal Reserve Bank of St. Louis, revised 07 Jun 2024.
    • Handle: RePEc:fip:fedlwp:94765
    DOI: 10.20955/wp.2022.022
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    More about this item

    Keywords

    liquidity; investment; present bias;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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