The Supply and Demand for Safe Assets

Abstract

Safe assets are demanded to smooth consumption across states (both intertemporally
and in cross-section). Some of these assets are supplied publicly (government
bonds) and some are created and supplied privately (such as mortgage-backed
securities and asset-backed securities). Private assets are created endogenously
when the supply of government bonds is low. Private assets are used as
collateral and come in heterogeneous quality. Financial fragility is the probability
that a large amount of private assets are examined, some are found to be of
low quality and then some firms cannot get loans. We characterize the government’s
optimal supply of government bonds when considering their effects on
the creation of private assets and on economy-wide fragility. We show that monetary
and macroprudential policies cannot be run in isolation. When there are too
many private assets the government should operate a Bond Exchange Facility that
exchanges private assets for public safe assets.

Keywords: safe assets, monetary policy, financial crises

JEL Classification: E3, E32, E40, E51