DP11242 | Private Money Creation and Equilibrium Liquidity

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We study the joint supply of public and private liquidity using a simple macroeconomic model. In a frictionless, competitive financial market, private intermediaries create riskless securities (safe assets) and the economy achieves the fi rst best. If instead equity is more costly than debt, a pecuniary externality arises, fi nancial intermediaries supply risky securities, and the economy is vulnerable to liquidity crunches. We use our framework to revisit, in the context of the modern financial system, some classic proposals on liquidity supply (real-bills doctrine, free banking, and narrow banking), comparing them with recent interventions (capital requirements and bailouts).