TY  - JOUR
AU  - Guerrieri,Veronica
AU  - Lorenzoni,Guido
TI  - Liquidity and Trading Dynamics
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 13204
PY  - 2007
Y2  - June 2007
UR  - http://www.nber.org/papers/w13204
L1  - http://www.nber.org/papers/w13204.pdf
N1  - Author contact info:
Veronica Guerrieri
University of Chicago
Graduate School of Business
5807 South Woodlawn Avenue
Chicago, IL 60637
Tel: 773/834-7834
Fax: 773/702-0458
E-Mail: vguerrie@chicagogsb.edu

Guido Lorenzoni
MIT Department of Economics
E52-251C
50 Memorial Drive
Cambridge, MA 02142
Tel: 617/253-4836
Fax: 617/253-1330
E-Mail: glorenzo@mit.edu
AB  - How do financial frictions affect the response of an economy to aggregate shocks? In this paper, we address this question, focusing on liquidity constraints and uninsurable idiosyncratic risk. We consider a search model where agents use liquid assets to smooth individual income shocks. We show that the response of this economy to aggregate shocks depends on the rate of return on liquid assets. In economies where liquid assets pay a low return, agents hold smaller liquid reserves and the response of the economy tends to be larger. In this case, agents expect to be liquidity constrained and, due to a self-insurance motive, their consumption decisions are more sensitive to changes in expected income. On the other hand, in economies where liquid assets pay a large return, agents hold larger reserves and their consumption decisions are more insulated from income uncertainty. Therefore, aggregate shocks tend to have larger effects if liquid assets pay a lower rate of return.
ER  -