When money matters: liquidity shocks with real effects John Driffill and Marcus Miller Birkbeck and University of Warwick

Abstract In their workhorse model of money and liquidity, Kiyotaki and Moore (2008) show how tightening credit constraints can cut current investment and future aggregate supply. Aggregate demand matches current supply, thanks to a flex-price Pigou effect Switching from a flex-price to a fix-price framework implies that demand failures can emerge after a liquidity shock. Quantitative estimates by FRBNY using such a framework produce dramatic results: what about the analytics?

Diagram 1. Effect of a stochastic liquidity shock in US that lasts 10 quarters, Del Negro et al. (2009)

Macro Paradigm: Woodfords Synthesis Interest and Prices (2003) marked decisive shift in monetary economics from looking at the quantity of money to the cost of borrowing (i.e. from Friedman back to Wicksell inspired by an over-arching vision: to create a new synthesis reconciling mainline macroeconomics with dynamic General Equilibrium (GE), as practised by RBC theorists in particular.

Hammonds view of GE without credit constraints?

The Arrow Debreu paradigm at risk? In the absence of collateral or other credible enforcement, Peter Hammond (1979) argued that, the core of the inter-temporal GE model is not sub-game perfect. Further discussion tomorrow? If this is true for Arrow-Debreu paradigm of GE, it is also true for the DSGE specialisation developed for macroeconomics. Does it matter?

Great Moderation has succumbed to credit crunch US unemployment rate has doubled from 4.8 per cent to 9.8 percent the world is currently undergoing an economic shock every bit as big as the Great Depression shock of Eichengreen and ORourke (2009). The good news is that the policy response is very different (zero interest rate, deficit spending, QE) The bad news is that it lies outside the reach of DSGE Can Kiyotaki and Moore (2008) model help?

KM(2008) framework addresses the Hammond critique of DGE: firms cannot borrow at will - with real consequences for composition of output. heterogeneous investors facing liquidity constraints want to hold money as a precaution against a lack of finance for investment opportunity need to add sticky wages/prices for liquidity shocks to have significant real effects; otherwise the Pigou effect acts as automatic stabiliser!

Woodfords synthesis: the New Paradigm

Kiyotaki and Moore(2008), but with sticky wages/prices as in FRBNY and Driffill/Miller

Fix price macro 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 of how liquidity contraction can cut income conditional on K and q.

Figure 3. Short-run determination of X and Y

Kiyotaki and Moore (2008): Liquidity, Business Cycles, and Monetary Policy Assets involved: Money and equity Money is liquid Equity is not (completely) 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

Flex price to Fix price

Workers – not the focus of attention Spend what they get Rational and forward-looking, but impatient and credit constrained. No borrowing They can hold money and equity if they choose Save nothing Consumption equals wages

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

Entrepreneurs – play central role, manage production and invest and hold assets 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 –Use money, other equity holdings, and current income to finance investment

Liquidity constraints – on investment Entrepreneurs can raise equity against up to a fraction θ of new investment. They can sell off a fraction φ t of pre-existing equity (theirs and others) n t Money is perfectly liquid

Entrepreneurs budget constraint Budget: p – price of money; q – equity price λ – 1-depreciation rate n equity held by entrepreneur Objective - max exp U:

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

Investment and Net Demand Investment demand Entrepreneurs income equals their demand (GM equilibrium).

Entrepreneurs Portfolio Balance (AM)

KM (2008): liquidity driven expansion, ϕ increases, equity more liquid

DM (2010): liquidity driven contraction

Saddle Path Dynamics in fix price case: driven by Asset Market and Investment disequilibrium

Using AM and RI to get phase diagram

liquidity shock shifts E to E': with stock market fall leading to recession – or recovery if shock is to be reversed

Figure 6. Numerical Results from DM simulation using FRBNY parameters

Calibration using FRBNY parameters (qtly) φ = 0.13 (fraction of existing assets an entrepreneur can sell); discount factor β = 0.99; fraction of new capital against which an entrepreneur can raise equity, θ = 0.13; probability of an entrepreneur having an idea for an investment, π = 0.075; the quarterly survival rate of the capital stock λ = [ our base case steady state: q = 1.12, r = , Mp/K =0.1171, K = 152.5, y =17.26]

Temporary and permanent liquidity shock

Table 2. Impact effects of a 20% cut in ϕ for different lengths of time

Figure 8. Tobins q and the capital stock between the wars

Figure 9. Bubble collapse preceding liquidity shock: like 1929

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 too: Quantitative Easing as the government supplies liquidity in exchange for corporate securities.

Conclusion Switching from a flex-price to a fix-price framework means that demand failures can emerge after a liquidity shock. AM and RI offer simple analytical treatment of impact and dynamic effects. Adding bubble might help explain the origin of the shock- its when the bubble bursts Need to add financial intermediaries to get to the heart of the matter

Current UK recession (blue ) relative to earlier recessions(brown: 1930s, green and yellow: oil shocks)

Titanic sinking

Titanic

Queen Hermione imprisoned for sixteen years: then came reconciliation

Time for a change in Macro? discredited and discarded in the stagflation that followed the oil price shocks of the 70s and 80s, the Keynesian paradigm of macroeconomic stabilisation has suffered in silence for many years. but the new DSGE paradigm failed to predict the credit crunch - or explain its effects. Lets briefly review recent fashions in macro