Credit and Liquidity in the Macroeconomy
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This dissertation studies the role of credit and liquidity in macroeconomic fluctuations. Chapter 1 analyzes the effect of endogenous unemployment risk on the dynamics of recovery from a liquidity trap. In a liquidity trap, an adverse demand shock raises unemployment and produces a period of slow hiring. Slow hiring further reduces demand, both for standard precautionary reasons and because credit conditions endogenously worsen, reducing households' ability to borrow and consume. Multiple equilibrium paths exist, and which one the economy follows depends on household expectations and the policy rule adopted by the central bank after the economy exits the trap. Employment remains depressed for a substantial period after an adverse shock because high unemployment increases the dispersion of household debt holdings, slowing the recovery of demand. I find that the initial household debt distribution significantly affects the economy's sensitivity to a demand shock, and study the role of central bank policy in mitigating the initial fall in employment and promoting faster recovery. Chapter 2 explores a novel channel through which financial shocks affect the real economy through the supply of liquidity. I consider a model in which firms require uncertain ongoing financing, and agency costs limit their ability to raise new funds. To secure future financing, firms hold assets to sell if needed, and purchase credit lines from financial intermediaries. I collectively refer to these instruments as liquidity. Financial intermediaries' ability to commit future funds depends on their capital. This creates a linkage between bank balance sheets and the aggregate supply of liquidity. Bank losses raise the liquidity premium and reduce investment. I analyze the optimal supply of public liquidity, and find that when private liquidity is scarce the government should issue bonds for their liquidity properties. I further find that the optimal supply of government debt is decreasing in bank capital. This suggests that in the wake of a financial crisis in which financial intermediaries suffer large losses, governments should increase debt issuance. Chapter 3 considers the distributive implications of financial regulation. It develops a model in which the financial sector benefits from financial risk-taking by earning greater expected returns. However, risk-taking also increases the incidence of large losses that lead to credit crunches and impose negative externalities on the real economy. A regulator has to trade off efficiency in the financial sector, which is aided by deregulation, against efficiency in the real economy, which is aided by tighter regulation and a more stable supply of credit.