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Bank money, aggregate liquidity, and asset prices

  • Junfeng Qiu

    (CEMA, Central University of Finance and Economics)

We 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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Article provided by Society for AEF in its journal Annals of Economics and Finance.

Volume (Year): 12 (2011)
Issue (Month): 2 (November)
Pages: 295-346

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Handle: RePEc:cuf:journl:y:2011:v:12:i:2:p:295-346
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  1. Liutang Gong & William Smith & Heng-fu Zou, 2011. "Asset Prices and Hyperbolic Discounting," CEMA Working Papers 486, China Economics and Management Academy, Central University of Finance and Economics.
  2. Bullard, James & Smith, Bruce D., 2003. "Intermediaries and payments instruments," Journal of Economic Theory, Elsevier, vol. 109(2), pages 172-197, April.
  3. Scott Freeman, 1993. "Clearinghouse banks and banknote over-issue," Research Paper 9326, Federal Reserve Bank of Dallas.
  4. Yongli Zhang, 2010. "Fluctuations of Real Interest Rates and Business Cycles," Annals of Economics and Finance, Society for AEF, vol. 11(1), pages 185-208, May.
  5. Jianjun Miao, . "Ambiguity, Risk and Portfolio Choice under Incomplete Information," Boston University - Department of Economics - Working Papers Series wp2009-019, Boston University - Department of Economics.
  6. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
  7. David Andolfatto & Ed Nosal, 2001. "A simple model of money and banking," Economic Review, Federal Reserve Bank of Cleveland, issue Q III, pages 20-28.
  8. Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996. "Currency Elasticity and Banking Panics: Theory and Evidence," Canadian Journal of Economics, Canadian Economics Association, vol. 29(4), pages 828-64, November.
  9. Benjamin Lester, 2006. "A Model of Interbank Settlement," 2006 Meeting Papers 282, Society for Economic Dynamics.
  10. Allen Head & Junfeng Qiu, 2011. "Elastic Money, Inflation, and Interest Rate Policy," Working Papers 1152, Queen's University, Department of Economics.
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