Endogenous Liquidity Supply
Duke University and NBER
Wilbur John Coleman II
Duke University, Fuqua School of Business-Economics Group
Christian T. Lundblad
University of North Carolina Kenan-Flagler Business School
November 4, 2010
AFA 2011 Denver Meetings Paper
We present a general equilibrium model to understand the implications of short-term debt playing a special role in an economy in providing liquidity and facilitating transactions. In our model the supplies of short-term public and private debt are an endogenous outcome of optimal actions by the treasury and private financial intermediaries. Our model leads to the following three predictions. (1) A higher supply of public debt leads to a lower liquidity premium on treasuries, which tends to raise its pecuniary return (i.e., risk free rate). (2) A higher supply of public debt leads to a lower supply of private debt as private financial intermediaries compete with government debt in providing liquidity services. (3) A rise in aggregate uncertainty leads to a fall in private sector debt and a rise in public debt. Using data from 1950 to 2009 we find strong empirical support for all these predictions. In all, our model helps understand fluctuations in the availability of short-term private and public debt in a changing macro-economic environment.
Number of Pages in PDF File: 40
Date posted: March 17, 2010 ; Last revised: September 19, 2012
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