Bank money, aggregate liquidity, and asset prices
AbstractWe build a general equilibrium model to analyze how the ability of banks to create money can affect asset prices and financial stability. In the model, demand for liquidity takes the form of demand for money to make payments. We show that banks can provide elastic aggregate liquidity by creating and lending out deposits, which will reduce the need for people to sell assets and help maintain asset price stability. We also compare two types of liquidity provision mechanisms. The first is liquidity-risk-sharing through a Diamond-and-Dybvig style coalition that pools together people¡¯s resources, and the second is liquidity provision by banks though money creation. We show that without elastic aggregate liquidity provided by banks, coalitions can not actually perform their risk-sharing function, their attempt to sell assets to raise liquidity will only make asset prices decrease further, without actually raising more liquidity for shareholders hit by liquidity shocks. However, with banks providing elastic aggregate liquidity, people can indeed achieve better risk-sharing though coalitions. Finally, we show that the central bank can help banks provide liquidity to the market by lending to banks at low interest rates during the inter-bank settlement process, so as to relax the liquidity constraint of banks.
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Bibliographic InfoArticle provided by Society for AEF in its journal Annals of Economics and Finance.
Volume (Year): 12 (2011)
Issue (Month): 2 (November)
Liquidity; Asset prices; Banking; Inside money; Monetary policy; Payment system;
Find related papers by JEL classification:
- E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
- E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
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