Imperfect knowledge, liquidity and bubbles

Abstract

This paper demonstrates that insufficient liquidity, in the form of a shortage of safe assets that are useful as collateral in facilitating exchange, can lead to substantial movements in asset prices. There is a single asset that yields a positive payoff stream and can be traded in a centralized market. The asset can also be used to facilitate exchange in decentralized, or over-the-counter, trade and if the asset is in sufficiently short supply the fundamental asset price includes a liquidity premium. Traders, though, have imperfect information about the future price at which the asset will trade and so they behave like a Bayesian who estimates an econometric forecasting model for the asset price that is updated in real-time via discounted least-squares. The paper has three primary results: first, a permanent decrease in the supply of safe assets can lead to a substantial over-shooting of the asset price from its fundamental value; second, an increase in collateral requirements can lead to a substantial overshooting of asset prices; third, when asset prices include a liquidity premium there can be recurrent bubbles and crashes that arise as endogenous responses to economic shocks.

Financial frictions, the housing market, and unemployment

“…Derivation of the wage equation (21) The …rm's surplus, J , is given by (18). From (8), (14), and (15) the value of an employed household holding its optimal level of liquid assets solves V 1;t = w 1;t + $ t + (1 )V 1;t+1 + V 0;t+1 ; 2 fh; gg;…”

“…While wealth e¤ects and employment risks are important our analysis emphasizes an "aggregate demand" channel according to which the availability of collateralized loans to households a¤ects …rms'expected revenue. 8 An alternative assumption is that recruiting is labor intensive (instead of goods intensive). In our context our assumption implies that changes in lending standards and …nancial frictions do not a¤ect the cost of hiring, such as wages of workers in human resources.…”

“…(The homeownership status is left implicit when writing the value functions.) From (8) ; W e;t is linear in the household's wealth, which includes its real estate and its labor income net of the debt incurred in the DM; the choice of real estate for the following period, a t+1 , is independent of the household's asset holdings in the current period, a t . Finally, the quantity of housing services rented by the household…”

“…From (8) and the clearing of the rental housing market, d t = A t , the rental price of housing solves…”

“…8 Our "competitive" case should be distinguished from the notion of competitive search where it is assumed that contracts are posted before matches are formed and search is directed. For this concept of equilibrium in a related model, seeRocheteau and Wright (2005).…”