Endogenous Liquidity and the Business Cycle

I study an economy where asymmetric information in the quality of capital endogenously determines the amount of liquidity available. Liquid funds are key to relax financial constraints on investment and employment. These funds are obtained by selling or using capital as collateral. Liquidity is determined by balancing the costs of obtaining liquidity under asymmetric information against the benefits of relaxingfinancial constraints. Aggregate fluctuations follow increases in the dispersion of capital quality which raise the cost of obtaining liquidity. The model can generate patterns for quantities and credit conditions similar to the Great Recession.