Easy Money: the Inefficient Supply of Inside Liquidity

Abstract

In modern market economies, money supply increasingly depends on liquid debt securities, such as deposits and commercial paper, created by financial intermediaries. However, the recent financial crisis has exposed the fragility of this source of liquidity. This paper outlines a model in which currency, safe liabilities, and risky liabilities all provide liquidity services. It shows that, by setting the inflation rate, the central bank introduces a wedge in consumption. Moreover, inflation determines the level of liquid assets, but its composition is left to the market. During normal times, intermediaries provide ample amounts of liquidity, while during a crisis there is a large drop in the liquidity supply because of defaults of risky securities. This equilibrium is inefficient because of a pecuniary externality, and optimal policy aims to reduce the supply of risky securities. Liquidity requirements and investment mandates fail to achieve the social optimum because they redistribute assets without curbing the issuance of risky securities. Nevertheless, there is an optimal inflation policy that addresses the inefficiency.

Keywords: Currency, Inside money, Liquidity requirements, Capital requirements

JEL Classification: E42, E51, G28