Liquidity, Contagion and Financial Crisis1

ment Banking Value Chain " sponsored by the Fédération Bancaire Française. All remaining errors are ours. In this paper we study the link between liquidity, firms ’ access to external finance, and the real economy. We show that there is a feedback mecha-nism from collateral requirements to the fire-sale price of capital goods. As a result, an “abnormality ” appears whereby supply and demand for liquidity both slope in the same direction. This generates a “multiplier ” that ampli-fies the effect of external shocks. Hence, a shock can become contagious and propel the economy into a financial crisis, whereby collateral is sold off below fundamental value and some companies become credit rationed. For inter-mediate levels of the shock, muliple equilibria appear where the government can costlessly implement policies to coordinate expectations away from dom-inated equilibria. For high levels of the shock, financial crisis is the unique equilibrium. The competitive-equilibrium probability of a financial crisis is strictly positive. Stabilization policies that inject liquidity or bailout com-panies may decrease the probability of a crisis and enhance welfare, but will have fiscal implications. We structure the model so that its key parameters have a simple corporate-finance interpretation. We use numerical examples to show that the model’s quantitative fit is surprisingly good. Perhaps the most important implication of these numerical examples is that the ex-ante welfare effect of the stabilizing policies is very small