DP8890 On the optimal supply of liquidity with borrowing constraints

Author(s): Francesco Lippi , Nicholas Trachter

Publication Date: March 2012

Keyword(s): Friedman rule , Heterogenous agents , Incomplete markets , Liquidity , Precautionary savings , State dependent policy.

JEL(s): E5

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP8890.asp.asp

We characterize policies for the supply of liquidity in an economy where agents have a precautionary savings motive due to random production opportunities and the presence of borrowing constraints. We show that a socially efficient provision of liquidity involves a trade-off between insurance and production incentives. Two scenarios are studied: if no aggregate information is available to the policy maker, constant flat expansions are socially beneficial if unproductive spells are sufficiently long. If some aggregate information is available, a socially beneficial state-dependent policy prescribes expanding the supply of liquidity in recessions and contracting it in expansions.