DP9537 Liquidity and Inefficient Investment

Author(s): Oliver Hart, Luigi Zingales
Publication Date: July 2013
Keyword(s): aggregate shocks, fiscal policy, liquidity, nonpledgeability, pecuniary externalities
JEL(s): E41, E51, G21
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9537

We study the role of fiscal policy in a complete markets model where the only friction is the non-pledgeability of human capital. We show that the competitive equilibrium is constrained inefficient, leading to too little risky investment. We also show that fiscal policy following a large negative shock can increase ex ante welfare. Finally, we show that if the government cannot commit to the promised level of fiscal intervention, the ex post optimal fiscal policy will be too small from an ex ante perspective.