Fragility of Money Markets
School of Finance Working Paper Series
We provide the first comprehensive theoretical model for money markets encompassing unsecured and secured funding, asset markets, and central bank policy. In our model, leveraged banks invest in assets and raise short-term funds by borrowing in the unsecured and secured money markets. We derive how funding liquidity across money markets is related, explain how a shock to asset values can lead to mutually reinforcing liquidity spirals in both money markets, and show how borrowers' flight-to-safety and risk-seeking behavior impacts their liability structure. We derive the socially optimal leverage ratio and funding structure, and show which combination of conventional and unconventional monetary policies and regulatory measures can reduce money market fragility.
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