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The Elastic Provision of Liquidity by Private Agents


  • 1

    Seminal work includes that by Jensen and Meckling (1976), Myers (1977), and Myers and Majluf (1984).

  • 2

    Important work on macroeconomic implications of agency frictions includes that by Bernanke and Gertler (1989), Holmström and Tirole (1997, 1998, 2001), and Kiyotaki and Moore (1997, 2005).

  • I have benefited enormously from the help and support of Andres Almazan, Dean Corbae, Scott Freeman, and Bruce Smith. The comments of Deborah Lucas, an anonymous referee, and Jack Barron have helped me to improve the paper substantially. Thanks are due also to seminar participants at Purdue University, the University of Texas Departments of Economics and Finance, and the 2003 Midwest Macroeconomics Conference. All errors are my own. This essay was previously circulated under the title “Endogenous Liquidity Provision.”


I study a model of investment by financially constrained firms that are heterogeneous with respect to their exposure to an aggregate liquidity shock. A firm that is susceptible to the shock will mitigate its exposure by purchasing claims issued by a firm that is not. Liabilities of an unaffected firm may earn a liquidity premium due to their fungibility, and because they are backed by productive investment, their supply is elastic to the demand. This segmentation implies that an aggregate liquidity shock has different consequences across sectors of the economy.