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A Theory of Liquidity and Regulation of Financial Intermediation

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  • Emmanuel Farhi
  • Mikhail Golosov
  • Aleh Tsyvinski

Abstract

This paper studies a Diamond–Dybvig model of providing insurance against unobservable liquidity shocks in the presence of unobservable trades. We show that competitive equilibria are inefficient. A social planner finds it beneficial to introduce a wedge between the interest rate implicit in optimal allocations and the economy's marginal rate of transformation. This improves risk sharing by reducing the attractiveness of joint deviations where agents simultaneously misrepresent their type and engage in trades on private markets. We propose a simple implementation of the optimum that imposes a constraint on the portfolio share that financial intermediaries invest in short-term assets.
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Suggested Citation

  • Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2008. "A Theory of Liquidity and Regulation of Financial Intermediation," Levine's Working Paper Archive 122247000000002006, David K. Levine.
    • Handle: RePEc:cla:levarc:122247000000002006
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    More about this item

    JEL classification:

    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G2 - Financial Economics - - Financial Institutions and Services
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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