Liquidity Scarcity, Project Selection, and Volatility

The severe contraction that followed the recent financial crisis highlighted the exposure of the real sector to financial markets and the volatility in credit conditions. Unreliability of future funding influences the way in which firms balance risks when choosing investment projects and designing financial arrangements. The present paper studies the behavior of project choice in an environment with financial frictions and its consequences for the aggregate behavior of the economy. I focus on responses to fluctuations in the external supply of liquidity and in the liquidity created by the entrepreneurial projects themselves. When shocks occur to external liquidity sources, such as changes in the cash-flows that support mortgage-backed securities or other non-corporate assets, these are transmitted through financial arrangements towards the real sector. The anticipation of these shocks and its reflection in asset prices influence project selection and change the pattern of fluctuations, creating additional comovement. Likewise, the anticipation of variations in the internal liquidity of firms, resulting from shocks to their productivity, changes their choice of projects. For moderate liquidity scarcity, the effect through project choice is shown to lead to the dampening of these underlying productivity shocks; while for more severe shortages, amplification emerges. Despite the possibility of excess exposure to risk being generated endogenously, allocations are constrained efficient. Policy implications are then discussed in light of this result.