Journal Article

A Theory of Liquidity and Regulation of Financial Intermediation

Emmanuel Farhi, Mikhail Golosov and Aleh Tsyvinski

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 76, issue 3, pages 973-992
Published in print July 2009 | ISSN: 0034-6527
Published online July 2009 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2009.00540.x
A Theory of Liquidity and Regulation of Financial Intermediation

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  • Financial Regulation
  • Intertemporal Choice and Growth
  • Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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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.

Keywords: D91; E61; G28

Journal Article.  9817 words.  Illustrated.

Subjects: Financial Regulation ; Intertemporal Choice and Growth ; Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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