Liquidity Provision and Financial Stability

William Chen and Gregory Phelan

No 2021-11, Department of Economics Working Papers from Department of Economics, Williams College

Abstract: When financial intermediaries’ key characteristic is provision of liquidity through their liabilities, with financial frictions the financial sector in the aggregate is likely to over-accumulate equity, thus decreasing liquidity provision and household welfare. Aggregate household welfare is therefore decreasing in the level of aggregate intermediary equity even though the individual value of intermediaries is increasing in equity, which is why intermediaries over-accumulate equity. Subsidizing intermediary dividends can improve welfare by encouraging earlier payout and decreasing aggregate equity in the financial sector. This policy increases the likelihood that intermediaries provide more liquidity and improves the stability of the economy, even though asset prices fall.

Keywords: Financial stability; Macroeconomic instability Macroprudential policy; Banks (search for similar items in EconPapers)
JEL-codes: E44 E52 E58 G01 G12 G20 G21 (search for similar items in EconPapers)
Pages: 68
Date: 2021-08-03
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-fdg, nep-isf, nep-mac and nep-mon
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Journal Article: Liquidity Provision and Financial Stability (2024)
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