COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1468

Non-Monotone Liquidity under-Supply

Ana Fostel and John Geanakoplos

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.

Keywords: Liquidity under-supply, Credit constraint, Non-monotonicity, Multiplier, Collateral equilibrium

JEL Classification: D51, E44, F30, G15