Economic Theory

, Volume 66, Issue 1, pp 213–233 | Cite as

Inefficient liquidity provision

Research Article


We prove that in competitive market economies with no insurance for idiosyncratic risks, agents will always overinvest in illiquid long-term assets and underinvest in short-term liquid assets. We take as our setting the seminal model of Diamond and Dybvig (J Polit Econ 91(3):401–419, 1983), who first posed the question in a tractable model. We reach such a simple conclusion under mild conditions because we stick to the basic competitive market framework, avoiding the banks and intermediaries that Diamond and Dybvig (1983) and others introduced.


Liquidity Constrained inefficiency Diamond–Dybvig models Fire sales 

JEL Classification

E44 D5 E43 E6 G18 



This paper grew from discussions in the Reading Group on Financial Markets and Macroeconomic Fragility at Yale University. We thank all participants. Thank you especially to Alexis Akira Toda for providing us with very useful and detailed comments.


  1. Allen, F., Gale, D.: Financial intermediaries and markets. Econometrica 72(4), 1023–1061 (2004)CrossRefGoogle Scholar
  2. Arrow, K.J: Aspects of the theory of risk-bearing. In: Yrjö Jahnsson Lectures, Yrjö Jahnssonin Säätiö, Helsinki (1965)Google Scholar
  3. Bhattacharya, S., Gale, D.: Preference shocks, liquidity and central bank policy. In: Barnett, W.A., Singleton, K.J. (eds.) New Approaches to Monetary Economics. Cambridge University Press, New York (1987)Google Scholar
  4. Diamond, D.W., Dybvig, P.H.: Bank runs, deposit insurance, and liquidity. J. Political Econ. 91(3), 401–419 (1983)CrossRefGoogle Scholar
  5. Ennis, H.M., Keister, T.: Optimal banking contracts and financial fragility. Econ. Theory 61, 335–363 (2016)CrossRefGoogle Scholar
  6. Fairchild, F.R., Furniss, E.S., Buck, N.S.: Economics. The Macmillan Company, London (1937)Google Scholar
  7. Farhi, E., Golosov, M., Tsyvinski, A.: A theory of liquidity and regulation of financial intermediation. Rev. Econ. Stud. 76, 973–992 (2009)CrossRefGoogle Scholar
  8. Fostel, A., Geanakoplos, J.: Collateral restrictions and liquidity under-supply: a simple model. Econ. Theory 35, 441–467 (2008)CrossRefGoogle Scholar
  9. Geanakoplos, J., Polemarchakis, H.M.: Existence, regularity, and constrained suboptimality of competitive allocations when markets are incomplete. In: Heller, W.P., Starr, R.M., Starrett, D.A. (eds.) Uncertainty, Information, and Communication, Essays in Honor of Kenneth Arrow, Chap 3, vol. 3, pp. 65–95. Cambridge University Press, Cambridge (1986)CrossRefGoogle Scholar
  10. Geanakoplos, J., Walsh, K.J.: Uniqueness and stability of equilibrium in economies with two goods, Cowles Foundation Discussion Paper No. 2050 (2016)Google Scholar
  11. Grochulski, B., Zhang, Y.: Optimal liquidity regulation with shadow banking, Federal Reserve Bank of Richmond Working Paper WP 15-12R (2016)Google Scholar
  12. Hazlett, D.: Deposit insurance and regulation in a Diamond–Dybvig banking model with a risky technology. Econ. Theory 9, 453–470 (1997)CrossRefGoogle Scholar
  13. Jacklin, C.J.: Demand deposits, trading restrictions, and risk sharing. In: Prescott, E.C., Wallace, N. (eds.) Contractual Arrangements for Intertemporal Trade. University of Minnesota Press, Minneapolis (1987)Google Scholar
  14. Kashyap, A.K., Tsomocos, D.P., Vardoulakis, A.P.: How does macroprudential regulation change bank credit supply? NBER Working Paper No. 20165 (2014)Google Scholar
  15. Lin, P.: Banking, incentive constraints, and demand deposit contracts with nonlinear returns. Econ. Theory 8, 27–39 (1996)CrossRefGoogle Scholar
  16. Villamil, A.P.: Demand deposit contracts, suspension of convertibility, and optimal financial intermediation. Econ. Theory 1, 277–288 (1991)CrossRefGoogle Scholar
  17. Yared, P.: Public debt under limited private credit. J. Eur. Econ. Assoc. 11, 229–245 (2013)CrossRefGoogle Scholar

Copyright information

© Springer-Verlag Berlin Heidelberg 2017

Authors and Affiliations

  1. 1.Department of EconomicsYale UniversityNew HavenUSA
  2. 2.Santa Fe InstituteSanta FeUSA
  3. 3.University of Virginia Darden School of BusinessCharlottesvilleUSA

Personalised recommendations