“When money matters: liquidity shocks with real effects” by John Driffill
Bickeck College, London
University of Warwick
How and why do financial conditions matter for real outcomes? The ‘workhorse model of money and liquidity' of Kiyotaki and Moore (2008) shows how a ‘Big Bang' enhancement of liquidity can stimulate investment and future aggregate supply, with full employment maintained by flexible prices. But an unexpected contraction of liquidity – though temporary – can lead to Keynesian demand failure if the flex-price assumption is dropped for goods and labour markets in excess supply. The ‘bootstrap' property of ‘regime-switching' models implies that the duration of this recession depends on expectations. Capital depletion during the recession may cause a supply bottleneck when liquidity is restored.