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Inefficient Liquidity Provision

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Abstract

We prove that in competitive market economies with no insurance for idiosyncratic risks, agents will always overinvest in illiquid long term assets and underinvest in short term liquid assets. We take as our setting the seminal model of Diamond and Dybvig (1983), who �rst posed the question in a tractable model. We reach such a simple conclusion under mild conditions because we stick to the basic competitive market framework, avoiding the banks and intermediaries that Diamond and Dybvig and others introduced.

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  • John Geanakoplos & Kieran James Walsh, 2017. "Inefficient Liquidity Provision," Cowles Foundation Discussion Papers 2077, Cowles Foundation for Research in Economics, Yale University.
    • Handle: RePEc:cwl:cwldpp:2077
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    File URL: https://cowles.yale.edu/sites/default/files/files/pub/d20/d2077.pdf
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    References listed on IDEAS

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    1. Geanakoplos, J. & Polemarchakis, H., 1985. "Existence,regularity, and constrained suboptimality of competitive allocations when the asset market is incomplete," LIDAM Discussion Papers CORE 1985037, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    2. John Geanakoplos & Kieran Walsh, 2016. "Uniqueness and Stability of Equilibrium in Economies with Two Goods," Cowles Foundation Discussion Papers 2050, Cowles Foundation for Research in Economics, Yale University.
    3. Borys Grochulski & Yuzhe Zhang, 2015. "Optimal Liquidity Regulation With Shadow Banking," Working Paper 15-12, Federal Reserve Bank of Richmond.
    4. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2009. "A Theory of Liquidity and Regulation of Financial Intermediation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 76(3), pages 973-992.
    5. Ana Fostel & John Geanakoplos, 2008. "Collateral restrictions and liquidity under-supply: a simple model," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 35(3), pages 441-467, June.
    6. Pierre Yared, 2013. "Public Debt Under Limited Private Credit," Journal of the European Economic Association, European Economic Association, vol. 11(2), pages 229-245, April.
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    Cited by:

    1. Toda, Alexis Akira, 2019. "Wealth distribution with random discount factors," Journal of Monetary Economics, Elsevier, vol. 104(C), pages 101-113.
    2. Thomas M. Eisenbach & Gregory Phelan, 2022. "Cournot Fire Sales," American Economic Journal: Macroeconomics, American Economic Association, vol. 14(3), pages 508-542, July.
    3. Geanakoplos, John & Walsh, Kieran James, 2018. "Uniqueness and stability of equilibrium in economies with two goods," Journal of Economic Theory, Elsevier, vol. 174(C), pages 261-272.

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    More about this item

    Keywords

    Liquidity; Constrained inefficiency; Diamond-Dybvig models; �re sales;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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