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Collateral Restrictions and Liquidity Under-Supply: A Simple Model

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Abstract

We show that very little is needed to create liquidity under-supply in equilibrium. Credit constraints on demand by themselves can cause an under-supply of liquidity, without the uncertainty, intermediation, asymmetric information or complicated international financial framework used in other models in the literature. We show that the under-supply is a non-monotone function of the demand distortion that causes it, a result that may have interesting implications for emerging markets economies. Finally, when we make the credit constraint endogenous, the inefficiency can be large due to the presence of a multiplier.

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File URL: http://cowles.econ.yale.edu/P/cd/d14b/d1468-r.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1468R.

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Length: 31 pages
Date of creation: Jun 2004
Date of revision: Aug 2006
Publication status: Published in Economic Theory (2008), 35: 441-467
Handle: RePEc:cwl:cwldpp:1468r

Note: CFP 1236.
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Keywords: Liquidity under-supply; Credit constraint; Non-monotonicity; Multiplier; Collateral equilibrium;

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References

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  1. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," Working Paper 99-15, Federal Reserve Bank of Atlanta.
  2. Diamond, Peter A, 1984. "Money in Search Equilibrium," Econometrica, Econometric Society, vol. 52(1), pages 1-20, January.
  3. Hyun Song Shin & Stephen Morris, 2004. "Liquidity Black Holes," Econometric Society 2004 North American Winter Meetings 620, Econometric Society.
  4. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
  5. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  6. Jones, Robert A & Ostroy, Joseph M, 1984. "Flexibility and Uncertainty," Review of Economic Studies, Wiley Blackwell, vol. 51(1), pages 13-32, January.
  7. Martin Shubik, 2000. "The Theory of Money," Cowles Foundation Discussion Papers 1253, Cowles Foundation for Research in Economics, Yale University.
  8. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
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Cited by:
  1. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715, Cowles Foundation for Research in Economics, Yale University.
  2. Franklin Allen, 2010. "Comment on "The Leverage Cycle"," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 67-73 National Bureau of Economic Research, Inc.
  3. Guembel, Alexander & Sussman, Oren, 2010. "Liquidity, Contagion and Financial Crisis," IDEI Working Papers 664, Institut d'Économie Industrielle (IDEI), Toulouse.
  4. Hanno Lustig, 2011. "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle," 2011 Meeting Papers 1443, Society for Economic Dynamics.
  5. Ana Fostel & John Geanakoplos, 2010. "Why Does Bad News Increase Volatility and Decrease Leverage?," Cowles Foundation Discussion Papers 1762R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2011.
  6. Eric van Wincoop & Cedric Tille & Philippe Bacchetta, 2010. "On the Dynamics of Leverage, Liquidity, and Risk," 2010 Meeting Papers 393, Society for Economic Dynamics.
  7. M. Peiris & Alexandros Vardoulakis, 2013. "Savings and default," Economic Theory, Springer, vol. 54(1), pages 153-180, September.
  8. Weerachart Kilenthong, 2011. "Collateral premia and risk sharing under limited commitment," Economic Theory, Springer, vol. 46(3), pages 475-501, April.
  9. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715R, Cowles Foundation for Research in Economics, Yale University, revised Jan 2010.

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