Liquidity and Safety over the Business Cycle

This paper builds on two empirical observations: (i) Early stages of the 2007/08 financial crisis were driven by a dry-up of liquidity, and (ii), more generally, fluctuations in the availability of safe and liquid assets are relevant drivers of the business cycle. In a medium-scale new-Keynesian model with heterogeneous firms, constraints on asset liquidity and asymmetric information about asset quality, we endogenize and study these fluctuations in liquidity and safety premiums. In particular, (i) using U.S. macroeconomic and financial data, we estimate the model to assess the relative importance of shocks to asset liquidity and safety over the business cycle; (ii) accounting for the effective lower bound on nominal interest rates we revisit the 2007/08 financial crisis in detail; (iii) we provide new theoretical insights on the so-called liquidity puzzle.