Easy Money: the Inefficient Supply of Inside Liquidity
The money supply composition has shifted towards liquid securities created by financial intermediaries. However, the recent financial crisis has highlighted the fragility of this source of liquidity. Therefore, I create a model where currency, safe liabilities and risky liabilities all provide liquidity services. During normal times, intermediaries are able to fully satiate the demand for liquidity. This corresponds to a large drop in liquidity supply during a crisis because of the defaults from risky liabilities. Nevertheless, a welfare maximizing planner would like to reduce or eliminate these changes in the supply of liquid asset. Liquidity and capital requirements can restore efficiency, but they are sensitive to calibration and may be ineffective when analyzed individually.
Work in Progress
Rational Inattention Bubbles