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Story - antoq - 10/18/2010 - 13:46 - 155 comments - 0 attachments
Recent work emphasizes that financial development can lead to more investment (for example, Ndikumana (2005)), while examining whether financial development itself actually causes growth (Manning (2003), Shan (2005), Rousseau and Sylla (2006)). The traditional finding that the investment&output ratio can positively affect growth, put forth in Kormendi and Meguire (1985), is updated by Gillman, Harris, and Mátyás (2004) on the basis that the investment to output ratio proxies the real rate of interest that largely determines the growth rate in the theoretic Euler equation. Including investment in growth regressions along with financial development has been found to leave the latter with no direct role per se, as in Dawson (2003) and Rousseau and Vuthipadadorn (2005). Aghion, Howitt, and Mayer&Foulkes (2005) include the level of output, instead of investment, and find no effect of financial development per se on growth. However they also include an interaction term between financial development and output which they find significant. Gillman et al. include investment in growth regressions amongst regions differing in their level of development, and find possible interaction between inflation and development in the way that they affect the growth rate. While the Aghion et al. interaction term suggests the investment role that financial development can play, the Gillman et al. interaction results suggest the exchange role that financial development can facilitate.
The possible growth interaction of inflation with financial development has had limited focus. Part of the dir culty here is in providing a standard definition of financial development, within a standard monetary growth framework. This can be viewed as the need to define financial development within a decentralized financial sector in which there exists a robust mixed exchange equilibrium of both money and credit, or money and interest earning demand deposits. The problem of finding a mixed equilibrium goes back, for example, to Wallacens (1980) overlapping generations model, in which there is no unique equilibrium between money and interest&earning assets that are a substitute for money. Specifically within the exchange framework, many approaches have been used to establish a mixed equilibrium, from putting money and credit, or money and demand deposits, in the utility function [Lucas and Stokey (1983), Hartley (1988), Englund and Svensson (1988), Einarsson and Marquis (2001), Christiano, Motto, and Rostagno (2003)], to generalized transaction cost functions including both shopping time [Bansal and Coleman (1996), Goodfriend (1997), Lucas (2000), Gavin and Kydland (1999),Canzoneri and Diba (2005)], and costly isoquant&like combinations of money and demand deposits (Einarsson and Marquis (2002)).
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.
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