Business, Liquidity, and Information Cycles

Abstract

Stock markets play a dual role: improve capital allocation across firms by conveying information about their fundamentals and provide liquidity to traders by quickly turning stocks into cash. We propose a trading model in which these two roles are endogenously related: if stocks are used more intensively for liquidity, then prices reveal less information. We structurally estimate stock price informativeness for several countries and show that it declines when alternative liquidity sources, such as the banking system, are in distress. To study the real effect of this mechanism, we devise a strategy to integrate our trading module into a dynamic general equilibrium model with heterogeneous firms. We calibrate the model to the US and show that in recessions, prices become more informative and allocation improves, but only if alternative sources of liquidity function normally. Otherwise, traders rely more on stock markets for liquidity, prices become less informative, allocation deteriorates, and the output loss is 43% larger.