This paper analyses how firms respond to liquidity shocks when asset prices are endogenously determined through matching frictions. Building on Holmstrom and Tirole (1998), our key innovation is that pecuniary externalities become technological when interacting with pledgeable asset constraints: fire-sale prices reduce effective pledgeable income and distort both investment scale and effort incentives, even without nominal changes to credit limits. Firms sort endogenously into internal liquidity (hoarding) and external liquidity (asset sales) based on heterogeneous shock probabilities. The competitive equilibrium features excessive reliance on external liquidity because firms fail to internalise how their strategy choice depresses fire-sale prices for others. Introducing asymmetric information amplifies these distortions: pooled debt contracts attract lower-productivity firms into external strategies, weakening effort incentives more severely. Investor behaviour creates a further feedback loop, with competitive liquidity provision paradoxically depressing fire-sale returns and distorting firm strategies. Policy interventions can restore efficiency: liquidity guarantees dominate under symmetric information, while government asset purchases at socially efficient prices improve outcomes under asymmetric information without exacerbating adverse selection.
