When Money Matters: Liquidity Shocks with Real

Effects

John Driffill and Marcus MillerBirkbeck and University of Warwick

Summary• Kiyotaki and Moore (2008) show how an unexpected

temporary tightening of credit cuts current investment and future supply.

• FLEXPRICE: With flexible prices and wages, aggregate demand matches current supply via a ‘Pigou effect’ and there’s no unemployment.

• FIXPRICE :If prices and wages are inflexible downward, demand failures and unemployment emerge

• But, given the capital depletion in the recession, deficient demand turns to excess demand as recovery progresses, i.e. there is a risk of ‘stagflation’.

Great Moderation has succumbed to credit crunch

• US unemployment rate has doubled from 4.8 per cent to

9.5 percent and may peak at 10.5-11

• “the world is currently undergoing an economic shock

every bit as big as the Great Depression shock of 1929-

302” , Eichengreen and O’Rourke (2009).

• “The good news is that the policy response is very

different.”

• The bad news is that this owes virtually nothing to

modern macro paradigm.

Kiyotaki and Moore (2008) Liquidity, Business Cycles, and Monetary Policy

• firms face credit constraints - with real consequences for composition of output.

• credit market imperfections lead to a precautionary demand for money.

Adding Non Market Clearing to KM

• With money wages and prices fixed, goods and labour markets may fail to clear (as in fix-price macroeconomics)

• cf. Akerlof and Shiller.

• Del Negro et al. at NY Fed have similar idea, using Calvo contracts

We turn to temporary equilibrium: French ‘fix-price macro’ Benassy*/Malinvaud

• Note that if prices are inflexible downward, there will be

no Pigou effect to stabilise aggregate demand in the

face of a fall of investment

• A fall in demand will contract employment if the real

wage is determined by bargaining, as argued for the UK

in Layard and Nickell, Alan Manning.

• Graphical representation follows

*Was Ph D student of Debreu at Berkeley

Short run determination of net output

45°

L

wage bill (w*L) Net Output (X=rK)

X

Marginal Product of Labour

Aggregate Demand

Bargaining Wage

w*

X

Net Output (X = rK) Xf

real wage rate

L

D(X;q;K;)

π+θ

E

E*

D

D*

The model in summary: Liquidity constraints

• Kiyotaki and Moore (2008) ‘Liquidity, Business Cycles, and Monetary Policy’

• Money and equity

• Money is completely liquid

• Equity is not so liquid – only a fraction of holdings can be sold each period– only a fraction of newly produced capital goods can

be financed by issuing new equity

Investment

Entrepreneurs can only finance investment using

money, selling existing equity claims to others,

raising equity on new capital, and spending out of

current income

Workers: trapped in time

• Spend what they get

• Rational and forward-looking, but impatient and credit

constrained.

• No borrowing

• They can hold money and equity if they choose

• But they choose not to save

• Consumption equals wages

Heterogeneous entrepreneurs

• May (prob π) or may not (prob 1-π) have an idea for a profitable investment

• Those with no ideas (no investment)– Consume – Save in form of money and equity holdings

• Those with an idea (Investors)– Buy new capital goods– Issue equity against them, i.e. borrow– Use money, other equity holdings, and current income

to finance investment

Liquidity constraints

• Entrepreneurs can raise equity against up to a fraction θ of new investment.

• They can sell of a fraction φt of pre-existing equity (theirs and others) nt

• But money is perfectly liquid

1 (1 ) (1 )t t t tn i n

1 0tm

Entrepreneur’s budget constraint

• Budget:

• p – price of money; q – equity price

• λ – 1-depreciation rate

• n equity held by entrepreneur

• Objective - max exp U:

1 1( ) ( )t i t t t t t t t t tc i q n i n p m m r n

log( )s tt s

s t

E c

Production

• CRS / C-D production function, capital and labour

• KM: wage clears labour market

• DM: fix money wage and price level – entrepreneurs keep the surplus

1t t t ty A k l

t t t t ty w l r k

Aggregate Demand (IS curve)

(1 )1 1

t t t t t t

t t Rt t t

r q K p Mq I

q K

( ) 1

( ) 11

t t t

t t t t t tRt t

r x qr x K I K p M

q

Investment demand

Aggregate demand (‘IS curve’)

1

1R t

t

qq

.

Portfolio Balance (LM)

1 1 1

1 1 1 1

1 1 1 1 1 1

1 1 1 1 1 1 1

/ /(1 )

/ (1 ) /

(1 )

t t t t tt s

t t t t

Rt t t t t t t t

t R st t t t t t t

r q q p pE

r q N p M

p p r q q qE

r q q N p M

1 (1 )st t t t tN I K K

q

K

U

E

K**

U

U'

K*

E'

U'

B

Relaxation of credit contraints in a fully employed economy

q

K

E

K**

C

K*

E'

B

U'

U'

A

A

I

N

Big bang with anticipated repeat

Path: EBICE’

q

Equity Price

K

Z Δ Q

E

Capital Stock

Z Δ K

SU

K*

KC

C

Zero net investment

ΔK/Δt = 0

Asset price stationary

Δq/Δt = 0 U

S

Dynamics of adjustment of q and K with spare capacity and constant prices and wages

Temp liquidity shock: stock market falls, K depleted – followed by recovery as liquidity is restored

q

Equity Price

K

R

E

Capital Stock

Liquidity Shock

S'S'

LS

SS

K*

E'

U'U'

K'

V

Policy: QE in Credit crunch

• With firms who want to invest more credit constrained -

and workers income constrained - no Pigou effect to

stimulate entrepreneurial consumption, a ‘credit crunch’

causes recession.

• The antidote discussed by KM should work here :

Quantitative Easing as the government supplies

liquidity in exchange for corporate securities (not

government bonds) .

• i.e. more like Fed policy than Bank of England

Adding (more) behavioural aspects

• Phase diagram can portray effects of an

asset price bubble as discussed in

Akerlof and Shiller’s book Animal Spirits

[Perhaps Paul De Grauwe’s approach to

‘animal spirits’ be incorporated by making

state contingent , so there’s less

innovation in recession?]

Supply bottleneck and bootstrap effects.

c

K

S'S'

E'

U''U''

K*

S'S'

SS

SS

U'U'

E

L R

E

F

U'U'

U''U''

S''S''

S''S''

N

R'F'

So far so Keynesian, but beware:

risk of a ‘supply

bottleneck’ after a

recession

45°

Net Output (X=rK)

X

Aggregate Demand

X

Net Output (X = rK) Xf

L

D(X;q;K;)

π+θ

E

E*

D

D*

I

q

Equity Price

K

R

E

Capital Stock

Liquidity Shock

S'S'

LS

SS

K*

E'

K'

V

Excess Demand

Deficient Demand

B

q

Equity Price

K

R

E

Capital Stock

Liquidity Shock

S'S'

LS

SS

K*

E'

K'

V

Excess Demand

Spare Capacity

B

Need to switch regime, like Neary Stiglitz(1983)?

Switch from spare capacity to excess demand in recovery: risk of ‘stagflation’?

KM framework introduces Keynesian elements into DSGE

• In Kiyotaki and Moore (2008) model, tightening credit constraints cut current investment and future aggregate supply.

• If prices are inflexible, downward Keynesian demand failure can emerge after a liquidity shock

• There is a risk of ‘stagflation’ as demand recovers faster than supply- so it’s back to flexprice growth modelling

Conclusion

• Modelling (severe) financial frictions creates role for money as the liquid asset

• Agents heterogeneous – get away from ‘representative household assumption’

• Credit crunch has real effects

• Route out of recession may encounter supply bottlenecks

• Simple schematic model

Impulse responses to negative liquidity shock

Impulse responses to negative liquidity shock

‘Calibration’

• φ = 0.2 (fraction of existing assets an entrepreneur can sell);

• discount factor β = 0.96;

• fraction of new capital against which an entrepreneur can raise equity, θ = 0.4;

• probability of an entrepreneur having an idea for an investment, π = 0.2;

• the annual survival rate of the capital stock λ = 0.8.

• M = 50; price of money p = 1.

• ρ =0.6 (survival rate of shock to φ)

• Steady state: q = 1.12; r = 0.252; K = 296; Mp/K = 0.169.