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Liquidity and Investment in General Equilibrium

This paper studies how trading frictions in financial markets impact firms’ investment and dividend policies, and explores its aggregate consequences. When equity shares trade in frictional asset markets, the firm’s problem is time-inconsistent, and it is as if it faces quasi-hyperbolic discounting. The transmission of trading frictions to the real economy crucially depends on the firms’ ability to commit. In a calibrated economy without commitment, larger trading frictions imply lower capital. In contrast, if firms can commit, trading frictions affect asset prices but have little effect on aggregate capital. Our findings rationalize several empirical regularities on liquidity and investment.

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