The Macroeconomics of Money Market Freezes

Javier Suarez and Max Bruche

No 7304, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper develops a tractable general equilibrium model in which money markets provide structural funding to some banks. When bank default risk becomes significant, retail deposit insurance creates an asymmetry between banks that operate in savings-rich regions, which can remain financed at cheap risk-free rates, and in savings-poor regions, which have to pay either large spreads in money markets or high rates for the scarce regional savings. We show that this asymmetry can cause a severe distortion of the aggregate allocation of credit. When interdependencies across borrowers are large (e.g., via demand externalities), output and welfare losses are also large and can be dramatically reduced by an aggressive subsidization of money market borrowing. The analysis offers some insights on the rationale for responding to a money markets freeze with full-allotment fixed-rate lending policies by central banks or the extension of government guarantees on non-deposit liabilities.

Keywords: Deposit insurance; Financial crisis; Money markets; Spreads (search for similar items in EconPapers)
JEL-codes: E44 G15 G21 (search for similar items in EconPapers)
Date: 2009-05
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Working Paper: The Macroeconomics of Money Market Freezes (2009)
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