Precautionary Saving and Liquidity Shortage

Round 1

Reviewer 1 Report

 

Thank you for the opportunity to review this manuscript.

Here are my comments for the manuscript.

1.    1.  Please revise the abstract trying to show in a concise way what are the findings and the contribution of this manuscript

2.      2. Please edit the introduction to show the importance of the manuscript, what has been added to the literature, and what gap are the authors trying to fill.

3.      3. While the authors build an elaborate model to study the way firms deal with liquidity shortages, the authors do not sell their findings well in the introduction and conclusion.

4.      4. The authors need to add a section or expand the conclusion where they can explain in more depth the implications of their findings/model.

5.      5. The literature review seems to be thin. They have completely missed a literature where net debt (which includes liquid assets), payout and investment are interdependent and determined together.The following papers Lambrecht and Myers (2012 and 2017) develop theories that managers (executive team) choose to smooth payouts because they are trying to smooth their managerial rents. The managerial team would use debt (leverage) and investment (capital expansion) to make sure that payouts are smoothed. In addition, Hoang and Hoxha (2016 and 2021) show the same findings empirically respectively in United States and China. Denis and Osobov (2008) examine corporate dividend policies for firms in the US, Canada, UK, Germany, France and Japan, and find that highly profitable firms are more likely to pay dividends. Even if they cannot incorporate these findings in their model, the authors need to include them into the discussion for a wholesome picture of the literature.

6.      6. Please be consistent when citing papers. For example in line 31, the authors cite two papers just by numbering them [6, 7] and then put the name of author and number Ajello [8].

7.      7. In line 25 there is a repetition “lower zero lower”

8.      8. Please send the paper a review to an editor for English. Sometimes it is hard to follow what the authors are trying to state. For example in line 45 the authors write “Assume a discrete infinite horizon economy with firms and works”, and they keep repeating “works”. It was not clears what “works” meant, until later, I was able to guess the authors meant “workers”. The readers will have hard time to understand the contribution if this is not fixed.

9.      9. Please add more on how you contribute, and what makes this model stand out compared with the others done earlier. This would be more “marketing” for your own work.

 

References 

Lambrecht, B.M. and Myers, S.C. (2012), “A Lintner model of payout and managerial rents”, Journal of Finance, Vol. 67 No. 5, pp. 1761-1810.

Lambrecht, B.M. and Myers, S.C. (2017), “The dynamics of investment, payout and debt”, Review of Financial Studies, Vol. 30 No. 11, pp. 3759-3800.

Hoang, E.C. and Hoxha, I. (2016), “Corporate payout smoothing: a variance decomposition approach”, Journal of Empirical Finance, Vol. 35 No. 1, pp. 1-13.

Hoang, E.C. and Hoxha, I. (2021), "A tale of two emerging market economies: evidence from payout smoothing in China and Taiwan", International Journal of Managerial Finance, Vol. 17 No. 3, pp. 361-376.

Denis, D.J. and Osobov, I. (2008), “Why do firms pay dividends? International evidence on the determinants of dividend policy”, Journal of Financial Economics, Vol. 89 No. 1, pp. 62-82.

 

Author Response

Response to Reviewer 1 Comments

Point 1: Please revise the abstract trying to show in a concise way what are the findings and the contribution of this manuscript.

Response 1: Thanks for the helpful comment. As the flaws of the abstract have been pointed out by this comment and the comment from another reviewer, the entire abstract is now revised and reorganized with the following perspectives: (1) emphasize what has been missing in the previous studies (motivations). (2) What does our theory do and what gap is our theory trying to fill (novelty/contribution). (3) The main findings of our theory (findings). (4) The discussion of the feasible approaches for further studies, especially the empirical ones. The full text revised abstract is as follows.

 

“Most of the canonical macroeconomic models simulate liquidity anomalies by changing the economic fundamentals or adding massive financial shock to firms' collateral constraints, but a few facts somehow tell a different story. Instead of relying on the exogenous shocks, we introduce uncertainty into an otherwise classical liquidity framework and try to answer what worsens the aggregate liquidity in the absence of exogenous simulations, and what firm dynamics and financing strategy would be. Our analysis shows that (1) uncertainty induces agents to make decisions under the worst-case scenario and hence generates a unique expectation threshold that drags market (or firms) liquidity from sufficiency to insufficiency even without any shock or economic changes. (2) Precautionary saving occurs before the real liquidity shortage as the expectation shifts, causing firms to secure external financing by raising the equity issuing price and hoarding liquid assets, such as fiat money, against liquidity tightening. Other properties about firms’ intertemporal allocation, such as the bid-ask spread and return of holding the illiquid asset, are derived. Moreover, some approaches for further empirical research are discussed.”

 

Point 2: (1) Please edit the introduction to show the importance of the manuscript, what has been added to the literature, and what gap are the authors trying to fill. (2) Please add more on how you contribute, and what makes this model stand out compared with the others done earlier. This would be more “marketing” for your own work. (3) The authors need to add a section or expand the conclusion where they can explain in more depth the implications of their findings/model. (4) While the authors build an elaborate model to study the way firms deal with liquidity shortages, the authors do not sell their findings well in the introduction and conclusion.

Response 2: Thanks for these helpful comments, we apologize for having these comments merged since we think they are all highly connected and it would convey the revision and the associated explanation in a much better way if these suggestions are put into one unit.

 

To make the introduction more engaging, we first revise the motivation and try to make our study stand out. Specifically, a piece of evidence, on which the canonical macroeconomic models have limitations on the explanations, documented by an empirical study being brought out and it further raises two pivotal questions that echos our topic, these questions are the soul of our economic reasoning in this manuscript. The revision is as follows:

“Liquidity as the core factor in financial activities has deserved a lot of academic attentions especially since the onset of subprime crisis at 2008. The severe shortage of liquid assets during the subprime crisis prompted multiple authorities to inject a massive amount of liquidity into the market, in forms of bailouts and quantitative easing, etc. To characterize and replicate the crisis theoretically, one of the pivotal studies, Kiyotaki and Moore [1], incorporates firm's liquidity with the standard real business cycle model, opening the gate for macroeconomics to explore the firm dynamics and financing strategy along with the change of aggregate liquidity status. Be that as it may, such perfect model, like many other canonical macroeconomic models, blames exogenous shocks for the liquidity anomalies instead of agents' endogenous decision-making, it is therefore limited to explain some specific facts in reality. One robust example is the Knightian shares documented in Bachmann et al. [2]’s study: firms' uncertainty/Knightian share in Greece spiked up shortly after the victory of the Syriza party on January 25, 2015 and peaked when the repayment to an IMF loan was overdue on June 30. Neither fundamentals change nor prominent shock was found during this period, but uncertainty was reflected jointly in firm planning and observed risk premia in financial markets. With this in mind, we would like to ask two pivotal questions throughout the paper, what worsens the aggregate liquidity in the absence of exogenous simulation? How does firm act and cause this effect under uncertainty? These two unresolved issues, according to our perspective, happen to be the primary elements to better understand the volatility of liquidity.”

Except for the motivation part in the introduction, we also expand the literature review as the comment suggested, adding a new segment for the empirical studies, this will be shown in the next response. Moreover, to describe what has been added to the literature in this manuscript clearly and precisely, a short comment on the issues (or the missing pieces) that the theory/literature faces is supplemented in the revised manuscript:

 

“Two comments can be made from the related literature. First, recent empirical results are putting the evidence about precautionary hoarding of liquidity in a way that most of the canonical macroeconomic models cannot explain. For example, the system in macroeconomic model is staying at efficient equilibrium (or steady state) if no perturbation occurs, implying agent will not suddenly and willingly choose to hoard liquidity for precaution in the absence of exogenous shocks. However, Bachmann et al. [2] and Acharya and Merrouche [16] depict a contradicted story. Although a few studies in macro finance begin to emphasize the element of expectation-driven, the associated modeling, often known as the sunspot, can still be regarded as an exogenous shock, such as the bank run settings in Gertler et al. [24]. Second, tractability could be a main issue for macroeconomic models, especially the macro finance models, while concerning precautionary hoarding/saving. Take Maxted [25] as an example, diagnostic expectation, an extrapolative expectation that overreacts to noise and may lead to a precautionary behavior, is introduced to He and Krishnamurthy [26]’s macro finance model, but the basic solution to the model is numerical computation. Despite the numerical method being a good and efficient way to solve the precautionary saving puzzle, the analytical solution is always indispensable for putting the mechanism in a more concrete perspective and helping us better understand the reason why firms adopt these strategy rules/choices. These two comments are in line with the two unresolved questions that be asked at the beginning.”

 

Upon the short comment of related literature, we propose the contribution of our manuscript by explaining how the novel framework tackles the issues that prevent models/theories to describe/replicate the anomalies from a macroeconomics/macro-finance perspective, and also linking the strong evidence that a few preeminent empirical studies have documented to our contribution and findings in echoing the specific gap our theory trying to fill. The contribution part is as follows:

“This paper is contributing to the macro finance theory, the questions under our topic are responded with a modified liquidity framework where the investment chance is ambiguous. Specifically, we replace the exogenous shock in Kiyotaki and Moore [1] with the endogenous uncertainty and emphasize that the model's economy is without shocks and fundamentals change. Meanwhile, we solve the modified liquidity framework analytically and collect all the necessary conditions to judge and characterize firm dynamics and individual financing decisions, and further anatomize why these factors can cause precautionary saving and liquidity shortage. We discover a few broad conclusions upon our specific settings: (1) firms shift their expectations due to the existence of uncertainty, model endogenously generates a unique expectation threshold that drags the aggregate liquidity from sufficiency to insufficiency, implying the market could spontaneously experience liquidity shortage under uncertainty. This theoretical result matches Bachmann et al. [2]’s evidence that risk premia rise in Greece before the true debt crisis unfolds. (2) The shifted expectation induces firms to secure external financing by raising the equity issuing price and hoarding liquid assets, such as fiat money, as precautionary saving against liquidity tightening, which makes firms' precautionary saving behavior prior to the real liquidity shortage. In echoing Acharya and Merrouche [16] and Ashcraft et al. [17], this mechanism explains the spikes of liquidity demand in UK and US before the subprime crisis to some extent. Other properties about firms' intertemporal allocation, such as the bid-ask spread and return of holding the illiquid asset, are derived.”

 

Indeed, we must admit the original conclusion section is bland and less implicating like exactly the comment has pointed out. To fix these issues and enhance the quality of our manuscript, multiple revisions are implemented:

(1) Rewrite the beginning of the conclusion section to summarize/restate what are the goals of this manuscript and what has been done to achieve these goals.

(2) Revise the main findings more concisely and insightfully.

(3) Instead of adding an extra section, the implication of theoretical findings is connected to the specific evidence throughout the introduction and conclusion section, it helps better explain the mechanism detail behind those anomalies and reversely perceives the insight of our theory in a more natural way.

(4) Adding a discussion on the idea and approaches for further studies, especially the empirical ones.

The associated revisions can be found in the conclusion and introduction section, and we appreciate the reviwer’s efforts over these questions.

Point 3: The literature review seems to be thin. They have completely missed a literature where net debt (which includes liquid assets), payout and investment are interdependent and determined together.The following papers Lambrecht and Myers (2012 and 2017) develop theories that managers (executive team) choose to smooth payouts because they are trying to smooth their managerial rents. The managerial team would use debt (leverage) and investment (capital expansion) to make sure that payouts are smoothed. In addition, Hoang and Hoxha (2016 and 2021) show the same findings empirically respectively in United States and China. Denis and Osobov (2008) examine corporate dividend policies for firms in the US, Canada, UK, Germany, France and Japan, and find that highly profitable firms are more likely to pay dividends. Even if they cannot incorporate these findings in their model, the authors need to include them into the discussion for a wholesome picture of the literature.

Response 3: Thanks for the comment, we apologize for the negligence of the empirical literature and studies that cover the firm-level liquidity. As a revision, an extra part over these missing pieces is added to the literature review:

“For the empirical literature, Acharya and Merrouche [16] document that the liquidity demand of large settlement banks in UK experiences a 30% increase before the subprime crisis, and that strong precautionary nature makes the liquidity demand rise on days of high payment activity and for banks with greater credit risk. Ashcraft et al. [17] show a similar evidence but with the US data. Chiu et al. [18] examine the relationship between funding liquidity and equity liquidity during the subprime crisis by using the index and ETFs, the empirical results show that a higher degree of funding illiquidity leads to an increase in bid–ask spread and a reduction in both market depth and net buying imbalance. In a more broad scope, Belke et al. [19] take the liquidity shock to the open economy and emphasize that a global liquidity shock leads to a rise in consumer and global house prices, where the latter reaction is more pronounced. Except for these macro level studies, a few specific types of research concerning firm level liquidity and firm dynamics are also worth noting. Under the typical agency problem, Lambrecht and Myers [20 ,21] show that managers tend to smooth payouts in consideration of smoothing the rents they take from the firm, smoothing can either be done by lending (capital expansion) or borrowing (leverage). The basic reason for this behavior is that managers are risk aversion, and the authors give a few demonstrations of changing managers' preferences. Similarly, Hoang and Hoxha [22, 23] provide a more solid proof of smoothing behavior by the empirical results of US, China, and Taiwan, the authors find that firms use debt and investment to smooth a large fraction of shocks to net income to keep payouts less variable.”

 

Point 4: (1) Please be consistent when citing papers. For example in line 31, the authors cite two papers just by numbering them [6, 7] and then put the name of author and number Ajello [8]. (2) In line 25 there is a repetition “lower zero lower”. (3) Please send the paper a review to an editor for English. Sometimes it is hard to follow what the authors are trying to state. For example in line 45 the authors write “Assume a discrete infinite horizon economy with firms and works”, and they keep repeating “works”. It was not clear what “works” meant, until later, I was able to guess the authors meant “workers”. The readers will have hard time to understand the contribution if this is not fixed.

Response 4: Thanks for the comment, we are sorry for the carelessness during the writing, language and formatting check have been done multiple times during the revision process, and we hope all the errors are eliminated.

Author Response File: Author Response.docx

Reviewer 2 Report

Comments

Thanks for giving me an opportunity to review this interesting paper entitled “Precaution Saving and Liquidity Shortage”. This study find that (1) model exists a unique expectation threshold 2 that drags market (or firms) liquidity status from sufficient to insufficient even without any aggregate 3 shock or economic environment change; (2) firm tends to secure its external financing by raising 4 the equity issuing price and meanwhile hoarding liquid assets, such as fiat money, against liquidity shortage. Indeed, paper has a potential for policy suggestions and a fine piece of document. However, following are my concerns about the paper. The incorporation of these comments can enhance the quality of paper.

Revision Type: Major Revision

Comments

1.     The abstract is written in very informal way. Please add some motivation of study and policy outlays/novelty in abstract.

2.     JEL Classification is missing.

3.     No literature review discussion found. Although, the nature of paper is econometric reasoning, the authors need to discuss some recent student Introduction part is too dry. Please add the significance of study and relevant policies.

4.     The literature should be updated by recent literature.

5.     Discuss the main theories of liquidity and how the research framework based upon these theories.

6.     Please keep the formatting and font size same throughout the paper.

7.     Discussion and conclusion parts are ok.

 

8.     The author should focus more on language check. Best of luck.

Author Response

Response to Reviewer 2 Comments

 

Point 1: The abstract is written in very informal way. Please add some motivation of study and policy outlays/novelty in abstract. JEL Classification is missing.

 

Response 1: Thanks for the helpful comment. As has been pointed out, the main issue of the abstract is lacking the content of motivation and contribution. To fix this issue, the whole abstract is revised and reorganized with four small pieces: (1) point out what has been missing in the previous studies (motivations). (2) What does our theory do and what gap is our theory trying to fill (novelty/contribution). (3) The main findings of our theory (findings). (4) The discussion for further studies, especially the empirical ones. The revised abstract is as follows:

 

“Most of the canonical macroeconomic models simulate liquidity anomalies by changing the economic fundamentals or adding massive financial shock to firms' collateral constraints, but a few facts somehow tell a different story. Instead of relying on the exogenous shocks, we introduce uncertainty into an otherwise classical liquidity framework and try to answer what worsens the aggregate liquidity in the absence of exogenous simulations, and what firm dynamics and financing strategy would be. Our analysis shows that (1) uncertainty induces agents to make decisions under the worst-case scenario and hence generates a unique expectation threshold that drags market (or firms) liquidity from sufficiency to insufficiency even without any shock or economic changes. (2) Precautionary saving occurs before the real liquidity shortage as the expectation shifts, causing firms to secure external financing by raising the equity issuing price and hoarding liquid assets, such as fiat money, against liquidity tightening. Other properties about firms’ intertemporal allocation, such as the bid-ask spread and return of holding the illiquid asset, are derived. Moreover, some approaches for further empirical research are discussed.”

 

Meanwhile, we also apologize for the missing JEL Classification as we notice that the journal has no requirement for this detail. The JEL Classification of our manuscript should be E13, E31, E43 for the reviewer’s reference. We are grateful for such helpful advice.

Point 2: No literature review discussion found. Although, the nature of paper is econometric reasoning, the authors need to discuss some recent student Introduction part is too dry. Please add the significance of study and relevant policies. The literature should be updated by recent literature. Discuss the main theories of liquidity and how the research framework based upon these theories.

Response 2: Thanks for the comment. To make the introduction section less bland, we revise the entire first paragraph and bring out the anomalies that recent macro finance theory cannot explain and then ask pivotal questions under our topic, which are in echoing the reality facts that our theory trying to explain. Except for the theoretical studies, a few empirical studies that related to our topic are also added to the manuscript just for the sake of a wholesome picture of the literature. The new part for the empirical studies is as follows:

 

“For the empirical literature, Acharya and Merrouche [16] document that the liquidity demand of large settlement banks in UK experiences a 30% increase before the subprime crisis, and that strong precautionary nature makes the liquidity demand rise on days of high payment activity and for banks with greater credit risk. Ashcraft et al. [17] show similar evidence but with the US data. Chiu et al. [18] examine the relationship between funding liquidity and equity liquidity during the subprime crisis by using the index and ETFs, the empirical results show that a higher degree of funding illiquidity leads to an increase in bid–ask spread and a reduction in both market depth and net buying imbalance. In a more broad scope, Belke et al. [19] take the liquidity shock to the open economy and emphasize that a global liquidity shock leads to a rise in consumer and global house prices, where the latter reaction is more pronounced. Except for these macro level studies, a few specific types of research concerning firm level liquidity and firm dynamics are also worth noting. Under the typical agency problem, Lambrecht and Myers [20,21] show that managers tend to smooth payouts in consideration of smoothing the rents they take from the firm, smoothing can either be done by lending (capital expansion) or borrowing (leverage). The basic reason for this behavior is that managers are risk aversion, and the authors give a few demonstrations of changing managers’ preferences. Similarly, Hoang and Hoxha [22,23] provide a more solid proof of smoothing behavior by the empirical results of US, China, and Taiwan, the authors find that firms use debt and investment to smooth a large fraction of shocks to net income to keep payouts less variable.”

Moreover, to describe what has been added to the literature in this manuscript clearly and precisely, a short comment on the issues that the related theory/literature faces is supplemented to the revised manuscript:

“Two comments can be made from the related literature. First, recent empirical results are putting the evidence about precautionary hoarding of liquidity in a way that most of the canonical macroeconomic models cannot explain. For example, the system in macroeconomic model is staying at efficient equilibrium (or steady state) if no perturbation occurs, implying agent will not suddenly and willingly choose to hoard liquidity for precaution in the absence of exogenous shocks. However, Bachmann et al. [2] and Acharya and Merrouche [16] depict a contradicted story. Although a few studies in macro finance begin to emphasize the element of expectation-driven, the associated modeling, often known as the sunspot, can still be regarded as an exogenous shock, such as the bank run settings in Gertler et al. [24]. Second, tractability could be a main issue for macroeconomic models, especially the macro finance models, while concerning precautionary hoarding/saving. Take Maxted [25] as an example, diagnostic expectation, an extrapolative expectation that overreacts to noise and may lead to a precautionary behavior, is introduced to He and Krishnamurthy [26]’s macro finance model, but the basic solution to the model is numerical computation. Despite the numerical method being a good and efficient way to solve the precautionary saving puzzle, the analytical solution is always indispensable for putting the mechanism in a more concrete perspective and helping us better understand the reason why firms adopt these strategy rules/choices. These two comments are in line with the two unresolved questions that be asked at the beginning.”

Upon the short comment of related literature, we propose the contribution of our manuscript by explaining how the framework solves the issues that prevent models to describe/replicate the anomalies from a macroeconomics/macro-finance perspective, and also linking the strong evidence that a few preeminent empirical studies documented to our contribution and findings in echoing the specific gap our theory trying to fill. The last paragraph of the introduction section is as follows:

“This paper is contributing to the macro finance theory, the questions under our topic are responded with a modified liquidity framework where the investment chance is ambiguous. Specifically, we replace the exogenous shock in Kiyotaki and Moore [1] with the endogenous uncertainty and emphasize that the model's economy is without shocks and fundamentals change. Meanwhile, we solve the modified liquidity framework analytically and collect all the necessary conditions to judge and characterize firm dynamics and individual financing decisions, and further anatomize why these factors can cause precautionary saving and liquidity shortage. We discover a few broad conclusions upon our specific settings: (1) firms shift their expectations due to the existence of uncertainty, model endogenously generates a unique expectation threshold that drags the aggregate liquidity from sufficiency to insufficiency, implying the market could spontaneously experience liquidity shortage under uncertainty. This theoretical result matches Bachmann et al. [2]’s evidence that risk premia rise in Greece before the true debt crisis unfolds. (2) The shifted expectation induces firms to secure external financing by raising the equity issuing price and hoarding liquid assets, such as fiat money, as precautionary saving against liquidity tightening, which makes firms' precautionary saving behavior prior to the real liquidity shortage. In echoing Acharya and Merrouche [16] and Ashcraft et al. [17], this mechanism explains the spikes of liquidity demand in UK and US before the subprime crisis to some extent. Other properties about firms' intertemporal allocation, such as the bid-ask spread and return of holding the illiquid asset, are derived.”

We appreciate this helpful comment again, it indeed helps us enhance the quality of introduction.

Point 3: Please keep the formatting and font size same throughout the paper. The author should focus more on language check.

Response 3: Thanks for the comment, we apologize for the carelessness during the writing, language and formatting check have been done multiple times during the revision process, and we hope all the errors are eliminated.

Author Response File: Author Response.docx

Reviewer 3 Report

I like this paper very much  - it could be published after changes have been made. It is, for example, absolutely correct that with regard to the research question under investigation here the authors highlight the importance of the subprime crisis (which – according to their point of view – has been a turning point).

The model is very interesting. All calculations seem to be correct.

This paper clearly focuses on economic theory. However, I would suggest to also cite some empirical studies. Here I would suggest to highlight studies that examine data from the subprime crisis or other recent crisis events. Examples could be Acharya and Merrouche (2013), Chiu et al. (2012), Belke, Orth and Setzer (2008) and Wegener et al. (2019). This would also help to improve the literature review. Indeed, the literature review is still the major weakness of the paper. It would be very helpful if further connections to the literature (not only in theory) were shown. This could help to make this paper a widely cited study. With regard to this issue, the focus should not only be on the theoretical literature!

I would also suggest to discuss the general nature of the concept of liquidity in even more detail. It would certainly be helpful for the reader of the text to be told even more clearly what liquidity exactly is - and why this concept is so important!

The final section of the paper should also discuss possible approaches for further research. Especially empirical questions might be interesting at this point. How could researchers test the conclusions drawn in this paper?

There are also some minor points. Most importantly, the paper should be checked again (typos, gramma…just to give one example: ”Brunnermeier and Pedersen [5] thinks (…)”).

The following sentence should be rephrased: “Without showing the math, take investing firm as an intuitive example (…)”.

Would it make sense to show possible links to dividend policy issues?

 

Additional literature:

Acharya, V. V., & Merrouche, O. (2013). Precautionary hoarding of liquidity and interbank markets: Evidence from the subprime crisis. Review of Finance, 17, 107-160.

Belke, A., Orth, W., & Setzer, R. (2008). Sowing the seeds for the subprime crisis: does global liquidity matter for housing and other asset prices?. International Economics and Economic Policy, 5, 403-424.

Chiu, J. et al. (2012). Funding liquidity and equity liquidity in the subprime crisis period: Evidence from the ETF market. Journal of Banking and Finance, 36(9), 2660-2671.

Wegener, C. et al. (2019). Liquidity risk and the covered bond market in times of crisis: empirical evidence from Germany. Annals of Operations Research, 282, 407-426.

Author Response

Response to Reviewer 3 Comments

Point 1: This paper clearly focuses on economic theory. However, I would suggest to also cite some empirical studies. Here I would suggest to highlight studies that examine data from the subprime crisis or other recent crisis events. Examples could be Acharya and Merrouche (2013), Chiu et al. (2012), Belke, Orth and Setzer (2008) and Wegener et al. (2019). This would also help to improve the literature review. Indeed, the literature review is still the major weakness of the paper. It would be very helpful if further connections to the literature (not only in theory) were shown. This could help to make this paper a widely cited study. With regard to this issue, the focus should not only be on the theoretical literature!

Response 1: Thanks for the helpful comment concerning the literature review. Indeed, as this comment and other review comments have pointed out, the introduction section, especially the literature review part, is the major weakness of the manuscript, the associated issues can be seen as lacking the highlighting of empirical studies and the omission of review discussion, which make the introduction look bland. To make a good improvement, we cited a few preeminent empirical studies, as the comment suggested, that are highly related to our topic, and added a new segment to summarize the basic content and contributions of these studies. The revision is as follows:

“For the empirical literature, Acharya and Merrouche [16] document that the liquidity demand of large settlement banks in UK experiences a 30% increase before the subprime crisis, and that strong precautionary nature makes the liquidity demand rise on days of high payment activity and for banks with greater credit risk. Ashcraft et al. [17] show similar evidence but with the US data. Chiu et al. [18] examine the relationship between funding liquidity and equity liquidity during the subprime crisis by using the index and ETFs, the empirical results show that a higher degree of funding illiquidity leads to an increase in bid–ask spread and a reduction in both market depth and net buying imbalance. In a more broad scope, Belke et al. [19] take the liquidity shock to the open economy and emphasize that a global liquidity shock leads to a rise in consumer and global house prices, where the latter reaction is more pronounced. Except for these macro level studies, a few specific types of research concerning firm level liquidity and firm dynamics are also worth noting. Under the typical agency problem, Lambrecht and Myers [20,21] show that managers tend to smooth payouts in consideration of smoothing the rents they take from the firm, smoothing can either be done by lending (capital expansion) or borrowing (leverage). The basic reason for this behavior is that managers are risk aversion, and the authors give a few demonstrations of changing managers’ preferences. Similarly, Hoang and Hoxha [22,23] provide a more solid proof of smoothing behavior by the empirical results of US, China, and Taiwan, the authors find that firms use debt and investment to smooth a large fraction of shocks to net income to keep payouts less variable.”

Moreover, to describe what has been added to the literature in this manuscript clearly and precisely, we also added a segment of review discussion to tell the readers that the main issues (or missing pieces) of the related literature are (1) most of the macroeconomic models cannot explain the precautionary saving behavior in the absence of exogenous shock, and (2) the lacking of tractability prevents the further discussion on firm dynamics and financing strategy. The corresponding revision content is as follows:

“Two comments can be made from the related literature. First, recent empirical results are putting the evidence about precautionary hoarding of liquidity in a way that most of the canonical macroeconomic models cannot explain. For example, the system in macroeconomic model is staying at efficient equilibrium (or steady state) if no perturbation occurs, implying agent will not suddenly and willingly choose to hoard liquidity for precaution in the absence of exogenous shocks. However, Bachmann et al. [2] and Acharya and Merrouche [16] depict a contradicted story. Although a few studies in macro finance begin to emphasize the element of expectation-driven, the associated modeling, often known as the sunspot, can still be regarded as an exogenous shock, such as the bank run settings in Gertler et al. [24]. Second, tractability could be a main issue for macroeconomic models, especially the macro finance models, while concerning precautionary hoarding/saving. Take Maxted [25] as an example, diagnostic expectation, an extrapolative expectation that overreacts to noise and may lead to a precautionary behavior, is introduced to He and Krishnamurthy [26]’s macro finance model, but the basic solution to the model is numerical computation. Despite the numerical method being a good and efficient way to solve the precautionary saving puzzle, the analytical solution is always indispensable for putting the mechanism in a more concrete perspective and helping us better understand the reason why firms adopt these strategy rules/choices. These two comments are in line with the two unresolved questions that be asked at the beginning.”

Except for the literature review, we rewrote the rest of the introduction entirely and thoroughly. The revised introduction now mainly includes 3 aspects: (1) bring out the anomalies that recent macro finance theory cannot explain and then ask pivotal questions under our topic. (2) Review the related literature from both the theoretical and empirical persepective, followed by a discussion about the missing pieces of these studies and how are they related to our pivotal questions. (3) State the contribution of our manuscript and what gap we are trying to fill. The specific details are not going to be shown in the response just for the sake of succinctness. We thank you for this helpful comment again, it makes our manuscript stand out.

Point 2: I would also suggest to discuss the general nature of the concept of liquidity in even more detail. It would certainly be helpful for the reader of the text to be told even more clearly what liquidity exactly is - and why this concept is so important!

Response 2: Thanks for pointing out the exposition issue in our manuscript. As the comment said, our summary or introduction to the concept of liquidity is quite thin compared to its importance in reality. To fix this problem, we first added a short narrative before the start of the paper:

 

“Liquidity as the core factor in financial activities has deserved a lot of academic attentions especially since the onset of subprime crisis at 2008. The severe shortage of liquid assets during the subprime crisis prompted multiple authorities to inject a massive amount of liquidity into the market, in forms of bailouts and quantitative easing, etc.”

Then more details about the liquidity concept have been restated with the help of some empirical studies such as

“Acharya and Merrouche (2013) document that the liquidity demand of large settlement banks in UK experiences a 30% increase before the subprime crisis, and that strong precautionary nature makes the liquidity demand rise on days of high payment activity and for banks with greater credit risk. Ashcraft et al. (2011) show a similar evidence but with the US data.”

Due to our study being within the scope of macro finance theory, and as many other macro finance papers do, we must admit that it is a shame to not put the liquidity concept into the corporate finance level definition but focus on the macro level index/status. And we thank you again for this helpful comment.

Point 3: The final section of the paper should also discuss possible approaches for further research. Especially empirical questions might be interesting at this point. How could researchers test the conclusions drawn in this paper?

Response 3: Thanks for the comment, this is quite important to our manuscript. In light of this suggestion, we expanded the conclusion with a discussion of further studies where some computation methods and thoughts are used for testing our theory. Specifically, our novel liquidity framework can be solved for the transitional path to match the reality data according to the standard of macroeconometrics or quantitative macroeconomics, which needs to (1) pin down the measure of ambiguous, (2) calibrate the parameter array and some values of state variables at steady state (as summarized in the conclusion section), and (3) exploit multiple specific projection methods for function approximation. The associated revision can be found in the last section, and we thank you again for this meaningful comment.

Point 4: There are also some minor points. Most importantly, the paper should be checked again (typos, gramma…just to give one example: ”Brunnermeier and Pedersen [5] thinks (…)”). The following sentence should be rephrased: “Without showing the math, take investing firm as an intuitive example (…)”.

Response 4: Thanks for the comment, we apologize for the carelessness during the writing, and language check have been done multiple times during the revision process, we hope all the typos and grammar issues are eliminated. We appreciate this comment again.

Point 5: Would it make sense to show possible links to dividend policy issues?

Response 5: Thanks for the comment. Indeed, aggregate liquidity, especially the stock market liquidity, is highly connected to the firms’ dividend policy. For example, the recent study Lai et al (2020) conduct an empirical survey on a sample of 52 countries and find that the negative association between stock market liquidity and dividends exists and becomes even more pronounced in countries with sound political institutions. Nonetheless, we must admit that a detailed dividend rule is neither modeled nor derived from our framework, lacking the background/proof for us to discuss the dividend policy according to our theory even though the empirical evidence is significant. We want to thank the reviewer’s efforts on this issue.

 

Author Response File: Author Response.docx

Round 2

Reviewer 1 Report

The authors have addressed all my concerns.

Author Response

Thanks for the reviewer’s efforts to make this paper to a higher level.

Reviewer 2 Report

accept 

Author Response

Thanks for the reviewer’s efforts to make this paper to a higher level.

Reviewer 3 Report

This nice paper has been improved considerably. The literature review still is somewhat of a weakness. Here some further improvements could be helpful. Then, this could become a widely cited paper. I urge the authors to examine additional crisis events that have had implications for market liquidity. In fact, some additional literature should be cited. Especially Cao and Petrasek (2014) and Wegener et al. (2019) would clearly be excellent candidates. 

Additional literature:

Cao, C., & Petrasek, L. (2014). Liquidity risk in stock returns: An event-study perspective. Journal of Banking and Finance, 45, 72-83.

Wegener, C. et al. (2019). Liquidity risk and the covered bond market in times of crisis: empirical evidence from Germany. Annals of Operations Research, 282, 407-426.

Author Response

Please see the attachment.

Author Response File: Author Response.docx