Public Liquidity and Financial Crises

Abstract

Is the supply of public liquidity important for alleviating financial crises? I quantify a general equilibrium model featuring the liquidity insurance channel: Banks demand public liquidity as insurance against liquidation losses during banking crises. Cheaper liquidity insurance increases banks' liquidity buffer, which increases bank lending and thus output. Supporting this channel, the calibrated model explains 42% of variations in the liquidity premium. Counterfactual analyses reveal that without QE1, the cumulative output will be lower by at least 1.4%. However, due to large existing liquidity supply, the recent QE infinity in response to the coronavirus is much less effective. Appendix can be found here: https://ssrn.com/abstract=3347232.