In times of economic distress, the demand for liquid assets typically increases. Facing the prospect of temporary shortfalls in revenue, agents tend to increase their precautionary reserves of cash, government bonds, gold or other safe assets. A symptom of this behavior is the counter cyclical pattern of various liquidity premia, measured by the spread between the yield of assets with different liquidity, e.g., between commercial paper and treasury bills of the same maturity. In recent emerging market crises, this phenomenon has been dubbed a “flight to liquidity.” What are the aggregate implications of this behavior? When agents scramble to build reserves of liquid assets in a recession, this might affect negatively their spending decisions. Can this amplify the initial shock which triggered the recession? In this paper, we explore these questions in a general equilibrium model with a single liquid asset, money, and decentralized production and exchange. We find that the answers to the questions above depend crucially on the total supply of liquidity in the economy. When this supply is abundant, a negative aggregate shock leads to a reduction in activity, but there is no amplification due to the agents’ precautionary behavior. When, instead, the real value of liquid balances is relatively low, an aggregate shock has a magnified effect on the economy, as agents reduce their consumption in an attempt to protect their reserves. In a simple quantitative exercise, we show that this effect can be sizeable, leading to an increase in aggregate volatility by up to 50%, in economies with severe shortages of liquid assets.
We consider a model of decentralized production and exchange in the tradition of search models with money. Agents are anonymous and, thus, credit arrangements are not feasible and transactions are financed using a government supplied asset. There is a large number of households made of a consumer and a producer. We introduce idiosyncratic uncertainty by assuming that producers are exposed to heterogeneous productivity shocks. Consumers have to make their consumption decisions before knowing the realized income of the producer. Therefore, consumption decisions are determined both by initial real money balances and by income expectations.
The government issues a fixed supply of interest-bearing notes, money, and pays a constant interest rate on them. The interest payments are financed by lump-sum taxation. The equilibrium real value of the money supply is an increasing function of the interest rate chosen by the government. Therefore, a regime with a high rate of return, is identified as a regime of “abundant liquidity.” To derive our main analytical results, we focus on two extreme regimes. In the first case, the rate of return is equal to the inverse of the agents’ discount factor. This is a “Friedman rule” regime and, in this case, the economy achieves the first-best allocation. In the second case, the rate of return is so low that agents expect to be liquidity constrained after any realization of their income shock. We refer to this case as a “fully constrained economy.” We then compare the effect of an aggregate shock in the two regimes described. Under the Friedman rule, real money balances are large and are sufficient to completely buffer agents’ consumption against temporary income losses.
Therefore, a change in the probability of low income realizations has no effect on consumption decisions. If there is a negative aggregate shock, there will be more producers with low productivity. These producers will charge higher prices and the consumers that buy from them will consume less. However, for given prices, the consumers’ behavior is unchanged. In a fully constrained economy, instead, future consumption will be affected by the realization of the income shock. In this case, consumption decisions today are affected by the probability attached to different income realizations. A bad aggregate shock, by increasing the probability of low income realizations, induces consumers to reduce spending and increase their precautionary reserves. This pushes down the demand curve facing each producer, and leads to a larger reduction in aggregate activity, compared to the Friedman rule economy.
The approach in this paper is closely related to the large literature on money in models with search, going back to Diamond (1984) and Kiyotaki and Wright (1989). The search model in Diamond (1981) has a built-in amplification mechanism, due to the assumption of increasing returns in the matching function. Our model shares his focus on coordination motives in decentralized trading, but we look at a different mechanism, which works through risk aversion and the precautionary behavior of agents. From a methodological point of view, our model uses quasi-linear preferences as in Lagos and Wright (2005) to simplify the analysis of the cross-sectional distribution of money balances.
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Liquidity and Spending Dynamics
