Publication Date: July 2004
We deﬁne liquidity as the flexibility to move goods (money) from one project (investment) to another. We show that credit constraints on demand by themselves can cause an under-supply of liquidity, without the uncertainty, intermediation, asymmetric information or complicated international ﬁnancial framework used in other models in the literature. In this respect liquidity is like a commodity: according to our oﬀsetting distortions principle, a distortion in the demand for any good can often be understood as an ineﬀiciency of supply.
We show that the liquidity under-supply is a non-monotone function of the credit constraint. This result is also a particular case of a more general principle applying to any commodity with supply alternatives: second best supply ineﬀiciency is non-monotone in the demand distortion. Deﬁning liquidity as flexibility ensures that there will be alternatives, and thus non monotonicity. If we interpret the credit constraints as the degree of ﬁnancial development in the economy, our second proposition suggests that when ﬁnancial markets are very undeveloped, as in some emerging markets, ﬁnancial innovation may paradoxically make government intervention (taxation) more necessary.
Finally, we think about the magnitude of the under-supply in the context of a speciﬁc demand distortion. We model the credit constraint by assuming that borrowers will default unless their promises are covered by collateral. Further, we assume that only an exogenous proportion beta of a durable good can serve as collateral. This parameter will represent the degree of ﬁnancial development of the economy. We show that when the price of the collateral is endogenous, the magnitude of the under supply can be much larger. Any policy intervention that aﬀects the interest rate in equilibrium will have two eﬀects on the borrowing constraint: a direct eﬀect, also present in the case when the credit constraint is exogenous, and an indirect eﬀect through the price of the collateral. We explore our ﬁndings by solving and simulating a particular case in which utilities for the consumption good and collateral are quadratic.
Liquidity under-supply, Credit constraint, Non-monotonicity, Multiplier, Collateral equilibrium
JEL Classification Codes: D51, E44, F30, G15