DP8890 On the optimal supply of liquidity with borrowing constraints

Author(s):	Francesco Lippi, Nicholas Trachter
Publication Date:	March 2012
Keyword(s):	Friedman rule, Heterogenous agents, Incomplete markets, Liquidity, Precautionary savings, State dependent policy.
JEL(s):	E5
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=8890

We characterize policies for the supply of liquidity in an economy where agents have a precautionary savings motive due to random production opportunities and the presence of borrowing constraints. We show that a socially efficient provision of liquidity involves a trade-off between insurance and production incentives. Two scenarios are studied: if no aggregate information is available to the policy maker, constant flat expansions are socially beneficial if unproductive spells are sufficiently long. If some aggregate information is available, a socially beneficial state-dependent policy prescribes expanding the supply of liquidity in recessions and contracting it in expansions.