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A Theory of Liquidity and Regulation of Financial Intermediation

  • Tsyvinski, Aleh
  • Golosov, Mikhail
  • Farhi, Emmanuel

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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File URL: http://dash.harvard.edu/bitstream/handle/1/4481504/Farhi_TheoryLiquidity.pdf
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Paper provided by Harvard University Department of Economics in its series Scholarly Articles with number 4481504.

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Date of creation: 2009
Date of revision:
Publication status: Published in Review of Economic Studies
Handle: RePEc:hrv:faseco:4481504
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  1. repec:cup:cbooks:9780521629560 is not listed on IDEAS
  2. Gary Gorton & Andrew Winton, 2002. "Financial Intermediation," Center for Financial Institutions Working Papers 02-28, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Hammond, Peter J, 1987. "Markets as Constraints: Multilateral Incentive Compatibility in Continuum Economies," Review of Economic Studies, Wiley Blackwell, vol. 54(3), pages 399-412, July.
  4. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
  5. Allen, Franklin, 1985. "Repeated principal-agent relationships with lending and borrowing," Economics Letters, Elsevier, vol. 17(1-2), pages 27-31.
  6. Andrew Atkeson & Robert E Lucas, 2010. "On Efficient Distribution with Private Information," Levine's Working Paper Archive 2179, David K. Levine.
  7. 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.
  8. Douglas W. Diamond, . "Liquidity, Banks and Markets," CRSP working papers 326, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  9. Richard Arnott & Joseph Stiglitz, 1982. "Moral Hazard and Optimal Commodity Taxation," Working Papers 500, Queen's University, Department of Economics.
  10. Mikhail Golosov & Aleh Tsyvinski, 2006. "Optimal Taxation with Endogenous Insurance Markets," Levine's Bibliography 784828000000000445, UCLA Department of Economics.
  11. Chiappori, P.A. & Macho, I. & Rey, p. & Salanie, B., 1994. "Repeated Moral Hazard: The Role of Memory, Commitment, and the Acces to Credit Markets," Papers 06, Laval - Laboratoire Econometrie.
  12. Richard Arnott & Joseph Stiglitz, 1990. "The Welfare Economics of Moral Hazard," NBER Working Papers 3316, National Bureau of Economic Research, Inc.
  13. Ricardo Caballero & Arvind Krishnamurthy, 2001. "Smoothing Sudden Stops," NBER Working Papers 8427, National Bureau of Economic Research, Inc.
  14. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, June.
  15. Mikhail Golosov & Narayana Kocherlakota & Aleh Tsyvinski, 2003. "Optimal Indirect and Capital Taxation," Review of Economic Studies, Wiley Blackwell, vol. 70(3), pages 569-587, 07.
  16. Alberto Bisin & John Geanakoplos & Piero Gottardi & Enrico Minelli & Heracles Polemarchakis, 2009. "Markets and Contracts," Working Papers 0915, University of Brescia, Department of Economics.
  17. Edward C Prescott & Robert M Townsend, 2010. "Pareto Optima and Competitive Equilibria With Adverse Selection and Moral Hazard," Levine's Working Paper Archive 2069, David K. Levine.
  18. Alberto Bisin & Adriano Rampini, 2006. "Exclusive contracts and the institution of bankruptcy," Economic Theory, Springer, vol. 27(2), pages 277-304, January.
  19. Stefania Albanesi, 2006. "Optimal Taxation of Entrepreneurial Capital with Private Information," NBER Working Papers 12419, National Bureau of Economic Research, Inc.
  20. 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.
  21. 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.
  22. Hellwig, Martin, 1994. "Liquidity provision, banking, and the allocation of interest rate risk," European Economic Review, Elsevier, vol. 38(7), pages 1363-1389, August.
  23. Narayana R Kocherlakota, 2005. "Advances in Dynamic Optimal Taxation," Levine's Bibliography 784828000000000518, UCLA Department of Economics.
  24. Greenwald, Bruce C & Stiglitz, Joseph E, 1986. "Externalities in Economies with Imperfect Information and Incomplete Markets," The Quarterly Journal of Economics, MIT Press, vol. 101(2), pages 229-64, May.
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