Liquidity, Efficiency and Bank Bailouts

Gary Gorton and Lixin Huang ()

No 9158, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Why do governments bailout banking systems in distress? We argue that the government can efficiently provide liquidity. We present a general equilibrium model in which not all assets can be used to purchase all other assets at every date. At some dates agents want to sell projects or securities. The only buyers are agents who have previously opportunistically invested in otherwise dominated assets because only these ( liquid') assets can be used to purchase the projects or securities. The market price of the projects or securities sold depends on the supply of liquidity, which is determined in general equilibrium. The supply of liquidity is not perfectly elastic so asset prices can deviate from efficient market' prices, that is, the conditional expectation of the asset payoff. While private liquidity provision is socially beneficial since it allows valuable reallocations, it is also socially costly since liquidity suppliers could have made more efficient investments ex ante. As a result, there is a potential role for the government to supply liquidity by issuing government securities, backed by tax revenue. Government bailouts of banking systems are an example of such public liquidity provision.

JEL-codes: E58 G21 (search for similar items in EconPapers)
Date: 2002-09
New Economics Papers: this item is included in nep-rmg
Note: CF
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Citations: View citations in EconPapers (4)

Published as Gorton, Gary and Lixin Huang. "Liquidity, Efficiency, And Bank Bailouts," American Economic Review, 2004, v94(3,Jun), 455-483.

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Journal Article: Liquidity, Efficiency, and Bank Bailouts (2004)
Working Paper: Liquidity, Efficiency and Bank Bailouts (2002)
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