A macroeconomic model of liquidity crises
We develop a macroeconomic model in which liquidity plays an essential role in the production process, because firms have a commitment problem regarding factor payments. A liquidity crisis occurs when firms fail to obtain sufficient liquidity, and may be caused either by self-fulfilling beliefs or by fundamental shocks. Our model is consistent with the observation that the decline in output during the Great Recession is mostly attributable to the deterioration in the labor wedge, rather than in productivity. The government’s commitment to guarantee bank deposits reduces the possibility of a self-fulfilling crisis, but it increases that of a fundamental crisis.
The Great Recession, that is, the global recession in the late 2000s, was the deepest economic downturn since the 1930s. Lucas and Stokey (2011), among others, argue that just as in the Great Depression, the recession was made severer by a liquidity crisis. A liquidity crisis is a sudden evaporation of the supply of liquidity that leads to a large drop in production and employment. In addition, the decline in output in the Great Recession was mostly due to deterioration in the labor wedge, rather than in productivity, as emphasized by Arellano, Bai, and Kehoe (2012).