Balance Sheet Recessions with Informational and Trading Frictions

Abstract

We consider a model of the balance sheet channel à la Kiyotaki and Moore (1997) but allow agents to trade claims contingent on aggregate states. We show that the interaction of information dispersion about aggregate states with trading frictions in secondary claims markets generates mispricing of aggregate risk, distorts the demand for state-contingent claims and limits aggregate risk-sharing, thereby giving rise to the balance sheet channel. The magnitude of aggregate fluctuations becomes tied to the severity of information-trading frictions and, as they vanish, the balance sheet channel disappears. Thus, the model suggests that the functioning of secondary claims markets has important implications for business cycles. Importantly, the laissez-faire equilibrium is constrained inefficient because information-trading frictions generate rent-extraction in secondary claims markets. Optimal policy targets the inefficiency at its source by promoting both issuance and trade of state-contingent claims in markets.