“Liquidity Flooding, Asset Prices and the Real Economy” by Xuewen Liu
Hong Kong University of Science and Technology
This paper develops a model for understanding the relationship between liquidity injections, asset prices, and growth of the real economy. We study the interaction between two sectors in the economy with different degrees of financial friction in the context of liquidity injections for economic stimulus. We show that if too much liquidity is injected into the economy, overheating can build up in the sector with lower friction (e.g., the financial sector), crowding out the demand for liquidity in the sector with higher friction (e.g., the real sector). The crowding-out occurs in a self-reinforcing spiral because of feedback between liquidity inflows, asset prices and firm asset collateral values. The crowding-out effect originates in the different degrees of asset specificity across the two sectors. The model characterizes conditions under which crowding-out is more likely, with empirical implications. The paper highlights the effect of financial frictions on the allocation and distribution of liquidity in an economy.