Abstract
We develop a model of financial intermediation characterized by an inside agency problem such that asset managers, when they have access to high enough liquidity, reach for yield by overinvesting in risky assets and concurrently underinvesting in safer or medium-risk assets. The managers follow a pecking order whereby their first preference is to invest in risky assets; their second preference is to hoard liquid assets so as to provide a buffer against runs; and their last preference is to invest in medium-risk assets. This reaching-for-yield behavior of managers is conducive to the formation of in the market for risky assets and concurrently bubbles in the market for medium-risk assets. We show that loose monetary policy by reducing the cost of liquidity shortfalls suffered by financial intermediaries induces further reach for yield and amplifies the magnitude of and negative bubbles.The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2619004.
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