Liquidity allocation and endogenous aggregate risks

Abstract

This paper presents a continuous-time DSGE model that examines an endogenous mechanism for liquidity allocation between the real economy and the financial system, as well as its interaction with systemic risk. The model provides rationales for the phenomena of weak investment and a savings glut observed among non-financial corporations in major advanced economies during the recovery from the Great Recession. It highlights that physical capital has lower liquidity compared to its corresponding equities. By incorporating financial frictions, the model reveals that risk-averse entrepreneurs, who must bear a portion of their investment risks, have their investment decisions significantly shaped by their capital structure. When entrepreneurs face low net worth, they tend to reduce investments and increase holdings in financial assets as a risk hedge. This behavior shifts more funds into the financial system, potentially sparking a financial boom accompanied by elevated systemic risks, while contributing to a sluggish economic recovery.