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Liquidity and the Allocation of Credit: Business Cycle, Government Debt and Financial Arrangements

Filippo Taddei

No 65, Carlo Alberto Notebooks from Collegio Carlo Alberto

Abstract: I analyze the equilibrium level of liquidity and its relevance for the allocation of credit, when the notion of liquidity is related to private information. The general equilibrium analysis yields the following main implications: firstly, it provides an explanation of procyclical liquidity even in the presence of security endogeneity; secondly, it illustrates how government debt, by providing liquidity to an otherwise illiquid private market, encourages rather than “crowds out” private investment; thirdly, it offers a well defined notion of securities’ value, the liquidity of which is endogenously enhanced by the arrangements within financial markets. The approach jointly analyzes the three factors crucial to liquidity: (1) its level is endogenously determined through equilibrium pricing while entrepreneurs choose which security to issue; (2) the introduction of government debt has the two-fold effect of directly providing liquidity to entrepreneurs and indirectly influencing the type of securities they issue in equilibrium; (3) financial markets develop arrangements to allow the beneficial employment of securities, not only physical assets, as collateral (financial pyramiding).

Keywords: Liquidity; Collateral; Business Cycle; Government Debt; Financial Arrangements; Tranching; Financial Pyramiding. (search for similar items in EconPapers)
JEL-codes: E22 E44 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2007
New Economics Papers: this item is included in nep-dge and nep-mac
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