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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.

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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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  7. Gorton, Gary & Winton, Andrew, 2003. "Financial intermediation," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, pages 431-552 Elsevier.
  8. Mikhail Golosov & Narayana Kocherlakota & Aleh Tsyvinski, 2002. "Optimal Indirect and Capital Taxation," Levine's Working Paper Archive 391749000000000449, David K. Levine.
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  18. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, June.
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  24. Guesnerie,Roger, 1998. "A Contribution to the Pure Theory of Taxation," Cambridge Books, Cambridge University Press, number 9780521629560.
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