Easy Money: the Inefficient Supply of Inside Liquidity (New Version Coming Soon)
The supply of money has shifted towards liquid securities created by financial intermediaries. However, the recent financial crisis has highlighted the fragility of this source of liquidity. This paper outlines a model in which currency, safe liabilities, and risky liabilities all provide liquidity services. In times of stability, intermediaries can fully satisfy the demand for liquidity, while during a crisis, there is a large drop in liquidity supply because of defaults from risky liabilities. A welfare-maximizing planner aims to reduce or eliminate these fluctuations in the supply of liquid assets. Liquidity and capital requirements can restore efficiency, but they are sensitive to calibration and may be ineffective when analyzed individually.