Public Liquidity and Financial Crises

Abstract

This paper studies the equilibrium effect of public liquidity on financial crises. Banks borrow from households via insured deposits and partially runnable debt, and suffer endogenous funding withdrawals from households in crises. Holding public liquidity alleviates banks' liquidity problems. In equilibrium, a larger public liquidity supply reduces crisis severity, expands bank lending, but crowds bank deposits and increases bank vulnerability to real shocks. The model quantitatively explains 40% of Treasury liquidity premium variations. Counterfactual analyses reveal that QE1 significantly improves output, 20 times larger than QE3. However, QE infinity during COVID-19 increases bank fragility to real shocks and reduces output.

Keywords: public liquidity, financial crisis, liquidity premium, banking

JEL Classification: E44, E58, G10, G28