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Understanding the Impact of Liquidity on Asset Prices and Economic Stability

This paper discusses a dynamic model on liquidity and default in financial crises, highlighting the crucial role of liquidity shortages in crisis propagation. Offering insights into DSGE models used by central banks and the effects of a negative monetary policy shock, it raises questions on crisis modeling and optimal policy responses.

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Understanding the Impact of Liquidity on Asset Prices and Economic Stability

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  1. Liquidity Effects on Asset Prices,Financial Stability and Economic Resilience by D. Tsomocos and J.F. Martinez A Discussion By Maxim Nikitin

  2. The Main Idea of the Paper: • A dynamic stochastic general equilibrium model with endogenous liquidity and endogenous default • The main motivation: standard DSGE models abstract from endogenous default and do not allow for sudden shortages of liquidity that are so important in propagation of financial crises

  3. Valuable Contribution, because • DSGE models used by central banks were developed during the “Great Moderation” when financial crises in major developed countries seemed no longer relevant (if not impossible).

  4. A Negative Monetary Policy Shock • Raises interest rate and reduces the amount of liquidity in the system • Lowers the marginal cost of default • Increases the equilibrium level of default

  5. However, it is hard to discuss the paper, because: The paper is a part a ‘multi-paper’ project, that Dimitrios is working on, the papers use similar framework, but the space limitations of a single paper do not allow him and his coauthor to present all the essential elements of the model and solution.

  6. What can be done? • Have a complete version of the paper somewhere on the web (100+ pages, or whatever), that a person not familiar with their earlier works can read and understand. • Or write a book

  7. Questions • Is this a “crisis-only” model, or is it descriptive model of the economy in both, tranquil and crisis times? • What are the shocks that cause financial crises? • What is the optimal policy (monetary and regulatory) response to these shocks?

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