Quid Pro Quo: Liquidity Insurance in Dealer-Fund Network

This concluding chapter argues that the policy makers' vade mecum laid out in the previous chapter raises broader issues for the global monetary system. Notwithstanding the fact that some of the emerging markets may have liberalized their capital accounts prematurely, it questions whether emerging markets have further to gain from opening up, or indeed whether they would not be better off retaining restrictions on at least the riskiest forms of foreign liabilities and transactions. This is particularly pertinent since most of these countries do not enjoy the liquidity insurance provided by swap facilities let alone the reserve currency status. They are forced to self-insure through reserve accumulation, which is costly both to the country and to the international monetary system. Alternative forms of insurance could arguably yield favorable benefit–cost trade-offs, particularly if they result in a safer mix of flows that makes economies less prone to risks from changes in global push factors.

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Money, Banking, and Financial Markets

The Review of Economic Studies ◽

10.1093/restud/rdz051 ◽

2019 ◽

Vol 87 (5) ◽

pp. 2049-2086 ◽

Cited By ~ 2

Author(s):

David Andolfatto ◽

Aleksander Berentsen ◽

Fernando M Martin

Keyword(s):

Central Bank ◽

Financial Markets ◽

Dynamic Model ◽

Banking System ◽

Free Banking ◽

Lender Of Last Resort ◽

Fractional Reserve ◽

Deposit Contracts ◽

Liquidity Insurance ◽

Meaningful Role

Abstract The fact that money, banking, and financial markets interact in important ways seems self-evident. The theoretical nature of this interaction, however, has not been fully explored. To this end, we integrate the Diamond (1997, Journal of Political Economy105, 928–956) model of banking and financial markets with the Lagos and Wright (2005, Journal of Political Economy113, 463–484) dynamic model of monetary exchange—a union that bears a framework in which fractional reserve banks emerge in equilibrium, where bank assets are funded with liabilities made demandable in government money, where the terms of bank deposit contracts are affected by the liquidity insurance available in financial markets, where banks are subject to runs, and where a central bank has a meaningful role to play, both in terms of inflation policy and as a lender of last resort. Among other things, the model provides a rationale for nominal deposit contracts combined with a central bank lender-of-last-resort facility to promote efficient liquidity insurance and a panic-free banking system.

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