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Liquidity and Investment in General Equilibrium

This paper studies the implications of trading frictions in financial markets for firms' investment and dividend choices and their 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 and production. In contrast, if firms can commit, trading frictions affect asset prices but have no effect on capital and production. Our findings rationalize several empirical regularities on liquidity and investment.

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https://doi.org/10.20955/wp.2022.022