Liquidity Shocks in the Financial Sector and the Real Economy

This paper studies how liquidity shocks that affect financial intermediaries are propagated to the real economy. Loans made to firms by financial intermediaries reflect their current and future anticipated borrowing constraints. As a result firms face a higher borrowing costs not only when their productivity is low (i.e. credit risk premium) but also when financial intermediaries face tight borrowing constraints (i.e. liquidity risk premium). This liquidity risk faced by financial intermediaries can contribute to a reduction of real investment made by firms. A model calibrated to aggregate data shows that this additional channel can amplify the magnitude of a recession and slow down the recovery, as observed during the 2007-2009 financial crisis.