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Liquidity Provision, Interest Rates, and Unemployment

  • Guillaume Rocheteau

    ()

    (Department of Economics, University of California-Irvine)

  • Jose Antonio Rodriguez-Lopez

    ()

    (Department of Economics, University of California-Irvine)

This paper develops a model of the public and private provision of liquidity and its relation to unemployment. We extend the Mortensen-Pissarides model of the labor market by adding an over-the-counter (OTC) market. Trades in the OTC market are collateralized with liquid assets, which are created through the financing of firms and by some public entity. As a result, the real interest rate is endogenous and depends on the financing needs of firms, the liquidity needs of OTC-traders, and the public supply of liquidity. We show that under some conditions the policymaker faces a trade-off between the provision of liquidity to the OTC market and the need to keep the cost of financing firms low. When the unemployment is inefficiently high, it is optimal to keep liquidity scarce, thereby reducing the total surplus of OTC-traders, to lower interest rates and promote job creations. We study the dynamics of the labor market under a liquidity shortage and we introduce heterogeneity across private assets in order to illustrate how a shock to liquidity demand can generate collateral expansion.

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File URL: http://www.economics.uci.edu/files/docs/workingpapers/2012-13/rodriguez-11.pdf
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Paper provided by University of California-Irvine, Department of Economics in its series Working Papers with number 121311.

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Length: 49 pages
Date of creation: Jun 2013
Date of revision:
Handle: RePEc:irv:wpaper:121311
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