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A Theory of Liquidity and Regulation of Financial Intermediation

  • Emmanuel Farhi
  • Mikhail Golosov
  • Aleh Tsyvinski

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. Copyright , Wiley-Blackwell.

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Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 321307000000000326.

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Date of creation: 02 Sep 2006
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Handle: RePEc:cla:levrem:321307000000000326
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  4. Chiappori, P.A. & Macho, I. & Rey, P. & Salanié, B., 1989. "Repeated Moral Hazard: The Role of Memory, Commitment, and the Access to Credit Markets," DELTA Working Papers 89-18, DELTA (Ecole normale supérieure).
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  8. Peter J. Hammond, 1987. "Markets as Constraints: Multilateral Incentive Compatibility in Continuum Economies," Review of Economic Studies, Oxford University Press, vol. 54(3), pages 399-412.
  9. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  10. Tsyvinski, A. & Golosov, M., 2004. "Optimal Taxation with Endogenous Insurance Markets," 2004 Meeting Papers 124, Society for Economic Dynamics.
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  12. Ernst-Ludwig VON THADDEN, 1998. "Liquidity Creation through Banks and Markets : Multiple Insurance and Limited Market Access," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9820, Université de Lausanne, Faculté des HEC, DEEP.
  13. Ricardo Caballero & Arvind Krishnamurthy, 2001. "Smoothing Sudden Stops," NBER Working Papers 8427, National Bureau of Economic Research, Inc.
  14. Alberto Bisin & Adriano Rampini, 2006. "Exclusive contracts and the institution of bankruptcy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 27(2), pages 277-304, January.
  15. Richard Arnott & Joseph Stiglitz, 1986. "The Welfare Economics of Moral Hazard," Working Papers 635, Queen's University, Department of Economics.
  16. Bruce C. Greenwald & Joseph E. Stiglitz, 1986. "Externalities in Economies with Imperfect Information and Incomplete Markets," The Quarterly Journal of Economics, Oxford University Press, vol. 101(2), pages 229-264.
  17. Mikhail Golosov & Aleh Tsyvinski & Ivan Werning, 2007. "New Dynamic Public Finance: A User's Guide," NBER Chapters, in: NBER Macroeconomics Annual 2006, Volume 21, pages 317-388 National Bureau of Economic Research, Inc.
  18. Narayana R Kocherlakota, 2005. "Advances in Dynamic Optimal Taxation," Levine's Bibliography 784828000000000518, UCLA Department of Economics.
  19. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 928-56, October.
  20. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, December.
  21. Andrew Atkeson & Robert E Lucas, 2010. "On Efficient Distribution with Private Information," Levine's Working Paper Archive 2179, David K. Levine.
  22. Guesnerie,Roger, 1998. "A Contribution to the Pure Theory of Taxation," Cambridge Books, Cambridge University Press, number 9780521629560, November.
  23. Mikhail Golosov & Aleh Tsyvinski, 2007. "Optimal Taxation with Endogenous Insurance Markets," The Quarterly Journal of Economics, Oxford University Press, vol. 122(2), pages 487-534.
  24. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
  25. Hellwig, Martin, 1994. "Liquidity provision, banking, and the allocation of interest rate risk," European Economic Review, Elsevier, vol. 38(7), pages 1363-1389, August.
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