DP13091 | Private Money Creation, Liquidity Crises, and Government Intervention

Publication Date

07/31/2018

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Abstract

We study the joint supply of public and private liquidity when financial intermediaries issue both riskless and risky debt and the economy is vulnerable to liquidity crises. Government interventions in the form of asset purchases and deposit insurance are equivalent (in the sense that they sustain the same equilibrium allocations), increase welfare, and, if fiscal capacity is sufficiently large, eliminate liquidity crises. In contrast, restricting intermediaries to invest in low-risk projects always eliminates liquidity crises but reduces welfare. Under some conditions, deposit insurance gives rise to an equilibrium in which intermediaries that issue insured debt (i.e., traditional banks) coexist with others that issue uninsured debt (i.e., shadow banks), despite the two being ex ante identical.