Liquidity and Credit: Government Debt and Financial Arrangements as Credit Providers

(preliminary) I propose an integrated approach to analyze the equilibrium level of liquidity in the economy and its relevance to the allocation of credit across different technologies. The provided general equilibrium analysis bears the following main implications: firstly, it shows that security endogeneity is a crucial factor in the explanation of procyclical liquidity; secondly, there is a well defined notion of collateral, the liquidity of which is endogeously enhanced by the arrangements within financial markets; thirdly, it reinterprets government bonds, in their ability to provide liquid collateral, to encourage rather than crowd out private investment. The approach is integrated because it jointly analyses the three factors crucial to liquidity: (1) its level is endogenously determined through equilibrium pricing; (2) investors take into account the severity of asymmetric information (i.e. liquidity) in choosing which security to issue; (3) financial markets develop arrangements to allow the beneficial employment of securities, not only physical assets, as collateral. The arguments are presented in the context of a production economy where agents with linear preferences are privately informed about the quality of the assets (technology and securities) they hold.