Inside and Outside Liquidity
Jean Tirole, Bengt Holmström
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Why do financial institutions, industrial companies, and households hold low-yielding money balances, Treasury bills, and other liquid assets? When and to what extent can the state and international financial markets make up for a shortage of liquid assets, allowing agents to save and share risk more effectively?
These questions are at the center of all financial crises, including the current global one. In Inside and Outside Liquidity, leading economists Bengt Holmstrom and Jean Tirole offer an original, unified perspective on these questions. In a slight, but important, departure from the standard theory of finance, they show how imperfect pledgeability of corporate income leads to a demand for as well as a shortage of liquidity with interesting implications for the pricing of assets, investment decisions, and liquidity management.
The government has an active role to play in improving risk-sharing between consumers with limited commitment power and firms dealing with the high costs of potential liquidity shortages. In this perspective, private risk-sharing is always imperfect and may lead to financial crises that can be alleviated through government interventions. "
drafts, and Daron Acemoglu, Tobias Adrian, Bruno Biais, Olivier Blanchard, Jeremy Bulow, Ricardo Caballero, Douglas Diamond, Olivier Jeanne, Anyl Kayshap, Nobu Kiyotaki, Guido Lorenzoni, Thomas Mariotti, Ernesto Pasten, Adriano Rampini, Andrei Schleifer, Jeremy Stein, Robert Townsend, Robert Wilson, and Mark Wolfson for extensive conversations on the subject. Needless to say, we are entirely responsible for any mistakes that remain (comments can be addressed to us at email@example.com or jean.
Scheinkman (2009) argue that adverse selection may increase liquidity hoarding, but for a somewhat different reason. Their model involves two sets of players: long-term arbitrageurs (sovereign wealth funds, pension funds, etc.) that hoard costly liquidity to buy assets at cash-inthe-market prices (i.e., at a discount) and firms that face a liquidity need before the date of reckoning (i.e., before the final return on a project is realized). Uncertainty about the final profit of each firm unfolds
des Societes d'Assurance, Financiere de la Cite, Paul Woolley Research Initiative, and SCOR. Bengt Holmstrom thanks NBER and the Yrjo Jahnsson Foundation for support, Anyl Kayshap for the invitation to visit the Initiative on Global Markets at the University of Chicago in the Fall 2006, and John Shoven for the invitation to visit Stanford Institute of Economic Policy Research (SIEPR) in the Spring 2010. Some of the work on the book was done during these visits. Finally, our families and most
School. de Soto, H. 201)3. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. New York: Basic Books. Dewatripont, M., and J. Tirole. 1994. The Prudential Regulation of Banks. Cambridge: MIT Press. Dewatripont, M., J. C. Rochet, and J. Tirole. 2010. Balancing the Banks. Princeton: Princeton University Press. Diamond, D. 1984. Financial Intermediation and Delegated Monitoring. Review of Economic Studies 51 (3):39,3-414. Diamond, D. 1997. Liquidity, banks,
firms routinely hoard liquid funds, sometimes very large ones, both to cushion smaller liqu The model with a continuum of shocks highlights the fundamental trade-off facing the firm: that betw Equation (2.23)-or, equivalently, (2.24)-determines implicitly the second-best cutoff value p*. Note In this chapter we have introduced our basic model of liquidity demand. Firms demand liquidity, beca It may at first be surprising that investors knowingly fund projects with a negative continuation va