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  5. Public Liquidity and Financial Crises

American Economic Journal:
Macroeconomics

ISSN 1945-7707 (Print) | ISSN 1945-7715 (Online)

Public Liquidity and Financial Crises

  • Wenhao Li
American Economic Journal: Macroeconomics (Forthcoming)

Abstract

This paper studies the equilibrium effect of public liquidity on financial crises. Banks borrow from households via insured deposits and partially runnable debt, and suffer endogenous funding withdrawals from households in crises. Holding public liquidity alleviates banks' liquidity problems. In equilibrium, a larger public liquidity supply reduces crisis severity and expands bank lending, but it crowds bank deposits and increases bank vulnerability to real shocks. The model quantitatively explains 40% of Treasury liquidity premium variations. Counterfactual analyses reveal that QE1 significantly improves output, 20 times larger than QE3. However, QE policies raise bank fragility against non-financial shocks such as COVID-19.

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