Liquidity premium, collateral constraints and business fluctuations

This study develops a simple dynamic stochastic general equilibrium model with collateral constraints to explore the implications of liquid assets for business cycles and asset prices. In the presence of heterogeneity in liquidity between collateral asset types, not only the value of asset holdings but also their composition affects borrowing capabilities in the future, which is to be reflected in the forward-looking optimal decisions of creditconstrained entrepreneurs. Hence the substitutions between assets and changes in liquidity premium are entailed in the course of economic fluctuations, suggestive of non-neutral effects from introducing the liquid assets into the economy with only illiquid assets. The quantitative analyses for the model economy indicate that this asset heterogeneity in liquidity can enhance the existing credit cycle models in matching the moments for amplification and persistence. Further, it is noted that the present model can generate counter-cyclical liquidity premium which is quite close to the historical average without drastic parameterization.