Liquidity shocks and real GDP growth: Evidence from a Bayesian time-varying parameter VAR

Abstract

We examine the dynamic impact of liquidity shocks resonating in stock and housing markets on real GDP growth. We fit a Bayesian time-varying parameter VAR model with stochastic volatility to US data from 1970 to 2014. GDP becomes highly sensitive to house market liquidity shocks as disruptions in the sector start to emerge, yet more resilient to stock market liquidity shocks throughout time. We provide substantial evidence in favour of asymmetric responses of GDP growth both across the business cycle, and among business cycle troughs. Stock and house market liquidity shocks explain, on average, 17% and 35% of the variation in GDP during the Great Recession, respectively.

Understanding the Macroeconomic Impact of Illiquidity Shocks in the United States

“…As the actual real GDP growth rate fell by 2.887% and 5.280% in 2008 and 2009 respectively, illiquidity shocks to ILR t account for 18.563% of the variation in real GDP growth. This result is close to that reported in Ellington, Florackis, and Milas (), where stock market illiquidity shocks explained 17% of the overall variation in GDP growth during the Great Recession. Similar results are found for illiquidity shocks to , and the overall contribution of illiquidity shocks to on real GDP growth reductions is much smaller than ILR t and .…”

“…In sum, according to our historical decomposition analysis, we found that illiquidity shocks explain quarterly economic activity in recession periods well in terms of magnitude and direction. This confirms the view of Chen, Chou, and Yen () that the dynamic link between recessions and stock market liquidity is strong, and it also echoes the findings in Ellington, Florackis, and Milas () and Ellington () that the magnitude of the effect of illiquidity shocks on real GDP is likely to be greater in recession periods.…”

“…As we propose to use Amihud's () illiquidity ratio to identify illiquidity shocks, the question arises as to what mechanism lies behind the relation between illiquidity shocks and the macroeconomy. As shown in Ellington, Florackis, and Milas (), Amihud's () illiquidity ratio is consistent with the theoretical model in Kiyotaki and Moore (). In the model of Kiyotaki and Moore (), because of borrowing constraints, the entrepreneurs who have investing opportunities can sell their holdings of liquid assets to finance their investments.…”

“…The macroeconomic effects of illiquidity shocks have been typically investigated using linear VARs. However, some recent studies suggest possible nonlinear properties of such shocks in different phases of the business cycle (Ellington ; Ellington, Florackis, and Milas ). These studies find that the relevance of illiquidity shocks is much larger during recessions than nonrecession periods.…”

“…Furthermore, Chen, Chou, and Yen () also demonstrate that the stock market illiquidity ratio is a strong predictor of future recessions. Ellington, Florackis, and Milas () use a Bayesian time‐varying parameter vector autoregression (TVP‐VAR) with stochastic volatility to investigate illiquidity shocks to the stock market and housing market on real GDP in the United States. They find that illiquidity shocks explain a large portion of real GDP growth, particularly during crisis periods.…”