Liquidity provision, interest rates, and unemployment

The effective liquidity supply of the economy-the weighted-sum of all assets that serve as media of exchange matters for interest rates and unemployment. We formalize this idea by adding an over-the-counter market with collateralized trades to the Mortensen-Pissarides model. An increase in public liquidity through a higher supply of real government bonds raises the real interest rate, crowding out private liquidity and increasing unemployment. If unemployment is inefficiently high, keeping liquidity scarce can be socially optimal. A liquidity crisis affecting the acceptability of private assets as collateral widens the rate-of-return difference between private and public liquidity, also increasing unemployment. (C) 2014 Elsevier B.V. All rights reserved.