Endogenous Liquidity Supply

40 Pages Posted: 17 Mar 2010 Last revised: 19 Sep 2012

Ravi Bansal

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

Date Written: November 4, 2010

Abstract

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.

Suggested Citation

Bansal, Ravi and Coleman, Wilbur John and Lundblad, Christian T., Endogenous Liquidity Supply (November 4, 2010). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1572481 or http://dx.doi.org/10.2139/ssrn.1572481

Ravi Bansal

Duke University and NBER ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7758 (Phone)
919-660-8038 (Fax)

Wilbur John Coleman II

Duke University, Fuqua School of Business-Economics Group ( email )

Box 90097
Durham, NC 27708-0097
United States
(919) 660-7962 (Phone)
(919) 660-7971 (Fax)

Christian T. Lundblad (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-8441 (Phone)

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