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Title: The Macroeconomics of Money Market Freezes

Author(s): Max Bruche and Javier Suarez

Publication Date: May 2009

Keyword(s): deposit insurance, financial crisis, money markets and spreads

Programme Area(s): Financial Economics and International Macroeconomics

Abstract: This paper develops a tractable general equilibrium model in which money markets provide structural funding to some banks. When bank default risk becomes significant, retail deposit insurance creates an asymmetry between banks that operate in savings-rich regions, which can remain financed at cheap risk-free rates, and in savings-poor regions, which have to pay either large spreads in money markets or high rates for the scarce regional savings. We show that this asymmetry can cause a severe distortion of the aggregate allocation of credit. When interdependencies across borrowers are large (e.g., via demand externalities), output and welfare losses are also large and can be dramatically reduced by an aggressive subsidization of money market borrowing. The analysis offers some insights on the rationale for responding to a money markets freeze with full-allotment fixed-rate lending policies by central banks or the extension of government guarantees on non-deposit liabilities.

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Bibliographic Reference

Bruche, M and Suarez, J. 2009. 'The Macroeconomics of Money Market Freezes'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=7304