Endogenous liquidity and the business cycle

That is the title of a Saki Bigio paper, just published in the American Economic Review.  It is illustrative of the state of knowledge on how financial frictions contribute to the explanation of business cycles.  Here is the abstract:

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.

Here is an ungated copy of the paper (pdf).  It is not quite correct to call this “real business cycle theory,” yet nonetheless this work stands as a rebuttal to those who are fond of criticizing…real business cycle theory.