Liquidity When It Matters Most: QE and Tobin’s q

How and why do financial conditions matter for real outcomes? The ‘workhorse model of money and liquidity’ of Kiyotaki and Moore (2008) shows how--with full employment maintained by flexible prices--shifting credit constraints can affect investment and future aggregate supply. We show that, when the flex-price assumption is dropped, an adverse but temporary liquidity shock can rapidly lead to Keynesian-style demand failure. Optimistic expectations may speed recovery, but simulation results suggest that prompt liquidity infusion by the central bank--i.e. Quantitative Easing--is needed to check prolonged recession.