Easy Money: the Inefficient Supply of Inside Liquidity (Updated October 2021)
In modern market economies, money supply depends more on liquid debt securities, such as deposits and commercial paper, created by financial intermediaries. However, the recent financial crisis has exposed the fragility of this source of liquidity. This paper outlines a model in which currency, safe liabilities, and risky liabilities all provide liquidity services. During normal times, intermediaries can fully satisfy the demand for liquidity, while during a crisis there is a large drop in the liquidity supply because of defaults from risky securities. Optimal policy aims to reduce these fluctuations in the supply of liquid assets by reducing the supply of risky securities. When studied individually, lump-sum taxes, liquidity, or equity requirements all restore efficiency. However, the optimal policy rates are sensitive to the model parameterization and, in the case of capital requirements, do not rule out the inefficient equilibrium.