What happens when liquidity increases in credit markets and more funds are channeled from borrowers to lenders? We examine this question in a general equilibrium model where financial matchmakers help borrowers (firms) and lenders (households) search out and negotiate profitable matches and where the composition of heterogeneous borrowers adjusts to satisfy equilibrium entry conditions. We find that enhanced liquidity causes entry by all borrowers and tends to benefit low-quality borrowers disproportionately. However, liquid credit markets may or may not be associated with higher output and welfare. The result is determined by whether the effect of higher market participation outweighs that of lower average quality. The net effect depends crucially on the source of the liquidity shock (financial matching efficacy, productivity, or entry barriers).
JEL classification: C78, E44, G21
Key words: financial matchmaking, search and entry frictions, credit composition effects
The authors gratefully acknowledge valuable inputs from Peter Diamond, Boyan Jovanovic, Derek Laing, Neil Wallace, Ruilin Zhou, and participants at the 1999 Winter Meetings of the Econometric Society in New York, the 1999 Midwest Economic Theory Conference at Purdue University, the 1999 Midwest Macroeconomics Conference in Pittsburgh, and the 1999 Society for Economic Dynamics Conference in Sardinia, Italy. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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