Douglas Gale and Tanju Yorulmazer, March 2011
Abstract:Banks hold liquid and illiquid assets. An illiquid bank that receives a liquidity shock sells as
sets to liquid banks in exchange for cash. We characterize the constrained efficient allocation
as the solution to a planners problem and show that the market equilibrium is constrained
inefficient, with too little liquidity and ine¢ cient hoarding. Our model features a precautionary as well as a speculative motive for hoarding liquidity, but the ineffciency of liquidity
provision can be traced to the incompleteness of markets (due to private information) and
the increased price volatility that results from trading assets for cash.
Keywords: Interbank market, fire sale.
JEL classifications: G12, G21, G24, G32, G33, D8.
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