DP8511 Liquidity When It Matters Most: QE and Tobin?s q

Author(s): John Driffill, Marcus Miller
Publication Date: August 2011
Keyword(s): Credit Constraints, Liquidity Shocks, Temporary Equilibrium
JEL(s): B22, E12, E20, E30, E44
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8511

How and why do financial conditions matter for real outcomes? The ?workhorse model of money and liquidity? of Kiyotaki and Moore (2008) shows how--with full employment maintained by flexible prices--shifting credit constraints can affect investment and future aggregate supply. We show that, when the flex-price assumption is dropped, an adverse but temporary liquidity shock can rapidly lead to Keynesian-style demand failure. Optimistic expectations may speed recovery, but simulation results suggest that prompt liquidity infusion by the central bank--i.e. Quantitative Easing--is needed to check prolonged recession.