DP11242 Private Money Creation and Equilibrium Liquidity

Author(s): Pierpaolo Benigno, Roberto Robatto
Publication Date: April 2016
Date Revised: April 2017
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11242

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 first best. If instead equity is more costly than debt, a pecuniary externality arises, financial 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).