Discussion of Kiyotaki & Moore „Liquidity, Business Cycles, and Monetary Policy“ Gerhard Illing LMU Munich University/CESifo Banque de France – Bundesbank conference June 2009

Central issues A role for liquid assets in a RBC model motivated by real frictions Strength: Model response of output and asset prices to liquidity shocks Characterize aggregate fluctuations in an economy with real frictions; role for monetary policy to smooth fluctuations Skepticism: Does the model really help to understand the role of monetary policy in normal times or in times of stress?

Summary – Model setup Economy with heterogeneous agents. Workers are passive (needed as tax base) Entrepreneurs have stochastic investment opportunities –New capital needs to be funded: need to issue equity –Limited commitment: (1)Borrowing constraint: Productive entrepreneurs can finance only a fraction θ<1 with external funds (2)Resale-ability constraint: Only fraction φ<1 of equity can be resold each period!  Liquidity constraint Motivates a role for fiat money with dominated return: Potentially productive entrepreneurs prefer to hold a mix of liquid money and high yielding, yet illiquid equity claims

Summary – The main insights Productive entrepreneurs invest every penny – Binding liquidity constraint; no money holding; Unproductive entrepreneurs hold a portfolio mix with money and equity. Trade off: –Chance to become productive — Money is most liquid asset to finance investment –Risk to stay unproductive — Equity holdings yield higher return. Beautiful fairy tale: Elegant modeling of aggregate dynamics with heterogeneous agents; explicit closed form solution Derives some Keynesian features (Feedback between goods and asset market; Tobin’s Q) in a tractable dynamic general equilibrium model

Summary – The main insights What happens after a liquidity shock? –φ falls –Productive entrepreneurs can get less funds by selling equity  Equity less attractive among unproductive entrepreneurs –Falling asset price, rising value of money (flight to liquidity, deflation) –Falling investment –Rising consumption; decumulation of capital –…

Summary – The main insights Monetary policy? Open market operation: Buy (sell) equity by issuing (withdraw) money –Inefficiency of laissez-faire monetary economy: Consumption is not smooth. Policy response after a negative shock on φ: –Open market operation to increase the liquidity of the investing entrepreneurs, so –Investments and asset prices can be insulated from the liquidity shock, –Helps to smooth consumption!

Comments Optimal monetary policy: Implement Friedman rule to eliminate the frictions from liquidity constraints  Implement first best outcome Trust in money (government) substitutes for lack of trust in entrepreneurs. Why? Problem 1: Model does not respect Lucas critique Frictions (Borrowing and Resale-ability constraints) do not respond to policy changes Moral hazard of entrepreneurs may be affected by policy: Need to model the frictions from first principles to define the set of constrained efficient outcomes. Exogenous variations of θ and φ: Is a change in φ simply a change in belief? Cheap route: Ability to tax workers makes liquidity constraints of entrepreneurs non-binding

Comments Problem 2: Model is biased towards favoring central bank intervention Frictions θ, φ distort economy away from efficient outcome in just one direction: under-accumulation! Central bank intervention helps to smooth/ overcome frictions. Does not capture a key element of current debate. Model cannot address the notion of “Fool’s Gold” (Overinvestment; excessive risk taking) Allow for possibility of Ponzi or Madoff games (φ>1?)

Comments Alan Greenspan, Speech on Consumer Finance April 2005 θ  1; φ  1 “With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. … Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending“ Are recent times of stress just a temporary shock in the perception of φ?

Conclusion A compact, tractable framework to introduce a role for liquidity in standard RBC type models. Beautiful framework. But much more needs to be done!