Inside Liquidity

We study a model in which a special role for safe, short-term assets in facilitating financial intermediation encourages the private sector to issue these assets to supplement the public supply of safe, short-term assets, even though their role in providing liquidity can be put in jeopardy during financial panics that lead agents to question the low-risk nature of these assets. During “normal” times these assets are considered sufficiently safe so that they contribute to the supply of liquid assets, but in a financial panic their role in providing liquidity is great diminished, if not eliminated all together. In this paper we propose an endogenous mechanism by which assets are categorized as safe enough to offer liquidity services, or to lose such a status that had been previously acquired. Such a model seems to match key features of the data, both in normal times and during a financial panic. During a financial panic, e.g., the model matches the observed large rise in yield spread between commercial paper and T-bills, the fall in the supply of commercial paper, and a positive association between the real yield on T-bills and the overall supply of commercial paper plus T-bills. The model also reveals that the very mechanism that endogenously introduces a special role for assets in providing liquidity also opens up the economy to multiple equilibria, and that the features just mentioned are also consistent with an economy that jumps from a good equilibrium to a bad one, with no other change in fundamentals. ∗Duke University ([email protected]), and The University of North Carolina (Christian [email protected]). We wish to thank Ravi Bansal for many helpful comments.