Liquidity and the International Allocation of Economic Activity

This paper introduces a framework to study the linkages between the financial market for liquid assets and the international allocation of economic activity. Private assets’ liquidity properties -their usefulness as collateral or media of exchange in financial transactions – affect assets’ values and interest rates, with consequences on firm entry, production, aggregate productivity, and total market capitalization. In a closed economy, the liquidity market increases the size and productivity of the sector of the economy that generates liquid assets. In an open economy, however, cross-country differences in financial development - as measured by the degree of liquidity of a country’s assets - generate an allocation of real economic activity that favors the country that supplies the most liquid assets. In such a setting, trade liberalization magnifies the gap in economic activity between the countries.