Endogenous Liquidity Supply

Abstract

We present a general equilibrium model to understand the implications of short-term debt playing a special role in an economy in providing liquidity and facilitating transactions. In our model the supplies of short-term public and private debt are an endogenous outcome of optimal actions by the treasury and private financial intermediaries. Our model leads to the following three predictions. (1) A higher supply of public debt leads to a lower liquidity premium on treasuries, which tends to raise its pecuniary return (i.e., risk free rate). (2) A higher supply of public debt leads to a lower supply of private debt as private financial intermediaries compete with government debt in providing liquidity services. (3) A rise in aggregate uncertainty leads to a fall in private sector debt and a rise in public debt. Using data from 1950 to 2009 we find strong empirical support for all these predictions. In all, our model helps understand fluctuations in the availability of short-term private and public debt in a changing macro-economic environment.