Liquidity, Business Cycles, and Monetary Policy


This paper derives a model economy in which money and other assets carry different liquidity. The aim of the model is to investigate how economic activity and asset prices depend on changes in productivity and liquidity. Unlike common workhorse models in macroeconomics, such as the real business cycle model, money is explicitly modelled; however, it does not have any ‘special’ properties above being the most liquid of assets. The role of money in the model is that entrepreneurs occasionally need funds to finance investments, and two frictions in the financial market means that entrepreneurs may need money to finance these investments.

The first of these frictions is a constraint on borrowing: investing entrepreneurs can take out loans by issuing equity claims on their company’s future returns, which can be bought by other entrepreneurs or workers. However, the entrepreneurs can only commit to repay a fraction – denoted by θ – of the returns on the investment. If this fraction is insufficient to finance the entire investment the remainder must be self-financed using the entrepreneur’s wealth, which consists of money and claims in other companies. We can think of the self-financed share of the investment as the down payment on the loan, and a small value of θ means that there is a tighter borrowing constraint.

The second key friction in the model is a resalability constraint: all of the entrepreneur’s money holdings are readily available to use as a down payment (in this sense money is completely liquid), but only a fraction – denoted by ϕ – of the equity holdings in other companies can be monetized in a given period (making these assets less-than fully liquid). Because of this, the entrepreneurs may wish to hold some money in their portfolio at any given time and, hence, money has a role in this economy: it lubricates the financial market by allowing resources to flow from those without investment opportunities (the savers) to those with investment opportunities (the borrowers). In fact, the paper derives conditions on the constraints such that, if a particular combination of θ and ϕ is low enough, money circulates in the economy and serves to boost aggregate productivity. 

Having established the usefulness of money in this framework, the model can be used to study the role of money as the economy fluctuates. A particularly interesting application, which relates to the great recession in 2008, is that the model allows for an exploration of a liquidity shock, here defined as an event that makes holdings in other entrepreneurs’ equity less liquid, by allowing a smaller fraction of it to be resold in a given period (a fall in the ϕ-parameter). The direct effect of this shock is that entrepreneurs find it harder to afford the down payments required to borrow for investments, which lowers investment and subsequently aggregate productivity in the economy. There are also feedback effects through asset prices: as the liquidity of outside equity holdings drops its market price falls relative to the value of money, which increases the size of the down payment required to borrow and further exacerbates the constraints faced by investing entrepreneurs. These interaction effects between liquidity, asset prices, and aggregate productivity are not present in standard economic models of asset pricing and the macroeconomy, making the model a useful lens through which to analyse liquidity crises. 

The final part of the paper analyses the role of the government, or the central bank, when a liquidity shock occurs.  An extension to the model allows the central bank to intervene by issuing new money to purchase equity through open market transactions. Such a policy, which resembles some policies of the Federal Reserve Bank during the great recession, is shown to boost aggregate productivity during a liquidity crisis by replacing entrepreneurs’ illiquid assets for liquid money, which stimulates investment in the economy. The model presented here, and in particular the role of the central bank, bears resemblance to seminal work in monetary theory by Keynes (1936). However, its focus is different from the ‘New Keynesian’ school of thought, where price-stickiness plays a key role in how the central bank influences the economy, and is instead closer related to an earlier reading of Keynes, such as Tobin (1969), with an emphasis on liquidity and asset prices. 


Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan. 

Tobin, James. 1969. “A General Equilibrium Approach to Monetary Theory.” J. Money, Credit, and Banking 1 (February): 15–29. 

This summary was written by Paul Telemo