Liquidity Risk and Financial Competition: Implications on Asset Prices and Monetary Policy
Recent events in financial markets have led to a substantial decline in the number of financial institutions, which may affect the extent of financial competition. What are the implications of such outcome on the degree of risk sharing, asset markets, and monetary policy? In order to answer these questions, I develop a two-sector monetary growth in which money and financial institutions play important roles. Compared to a perfectly competitive financial sector, I demonstrate that imperfect competition in deposits and capital markets can have substantial adverse consequences on capital formation, assets prices, and the degree of risk sharing. More importantly, market power in financial markets may overturn the Tobin effect present under a perfectly competitive financial sector. This necessarily happens in economies with high degrees of liquidity risk and low levels of capital formation.
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