Essays on information, liquidity and financial frictions

This dissertation seeks to understand how financial frictions arise and how they can affect the economy, and explores the implications of financial frictions for monetary policy during crises. Specifically, Chapter 2 and 3 study the endogenous nature of information asymmetry and explore its implications for financial markets and the macro economy. Chapter 4 studies the potential side effects of large scale asset purchase by central banks. In Chapter 2, I study a dynamic economy in which the information on asset quality is asymmetric and the degree of information asymmetry endogenously varies with the macro-economy, which amplifies the effects of shocks. In the model, firms hold assets of heterogeneous quality and borrow for operating expenses. Production is subject to idiosyncratic shocks, which may force the firms to liquidate their assets to pay off debts. Firms are initially uninformed of the qualities of their assets, but they can acquire private information on their own assets at a cost. Private information is individually beneficial, but it creates a lemons problem that lowers market liquidity and distorts economic decisions. Adverse shocks trigger private information acquisition, which exacerbates the lemons problem. As results, market liquidity drops and economic activity declines. The model can generate larger fluctuations in financial and macroeconomic variables than an otherwise the same model with the level of information asymmetry being fixed. In Chapter 3, I provide a possible explanation for the countercyclical movements in the measures of asset return volatility. In the model, external financing is costly due to the information asymmetry between borrowers and lenders. When the borrowers' financial conditions are worsened, the costs of external financing rise. Borrowers respond by increasing their transparency to outside investors to mitigate information asymmetry, which helps reduce the external financing cost. As a result, returns on external financing instruments disperse and fluctuate more as more information is disclosed, leading to increases in the cross sectional dispersion and the time series volatility of returns. This model can generate countercyclical dispersion, volatility in returns and external finance premium, with correlation coefficients between pairs of these measures quantitatively in line with the data. In Chapter 4, I explore the potential side effects of central bank asset purchase. In the model, commercial banks and shadow banks hold liquid assets as part of their operations. Asset purchases by the central bank decreases the supply of liquid assets that shadow banks can directly hold. When commercial banks do not face binding leverage constraints, shadow banks respond by increasing their deposits in or credit lines from commercial banks and central bank asset purchases are neutral. In the presence of a binding leverage constraint, however, asset purchases create distortions that decrease shadow banks' liquidity holdings and their lending. While conventional wisdom says that central bank asset purchases should be expansionary, I show that central bank asset purchases are necessarily contractionary when the level of bank reserves is high.Ph.D.Includes bibliographical referencesby Wukuang Cu