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Public Liquidity and Financial Crises

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  • Wenhao Li

Abstract

This paper studies the equilibrium effect of public liquidity on financial crises. Banks borrow from households via insured deposits and partially runnable debt and suffer endogenous funding withdrawals from households in crises. Holding public liquidity alleviates banks' liquidity problems. In equilibrium, a larger public liquidity supply reduces crisis severity and expands bank lending but crowds bank deposits and increases bank vulnerability to real shocks. The model quantitatively explains 40 percent of Treasury liquidity premium variations. Counterfactual analyses reveal that QE1 significantly improves output, 20 times larger than QE3. However, QE policies raise bank fragility against nonfinancial shocks such as COVID-19.

Suggested Citation

  • Wenhao Li, 2025. "Public Liquidity and Financial Crises," American Economic Journal: Macroeconomics, American Economic Association, vol. 17(2), pages 245-284, April.
    • Handle: RePEc:aea:aejmac:v:17:y:2025:i:2:p:245-84
    DOI: 10.1257/mac.20210412
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    More about this item

    JEL classification:

    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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