TY - JOUR AU - Holmstrom,Bengt AU - Tirole,Jean TI - Private and Public Supply of Liquidity JF - National Bureau of Economic Research Working Paper Series VL - No. 5817 PY - 1996 Y2 - November 1996 UR - http://www.nber.org/papers/w5817 L1 - http://www.nber.org/papers/w5817.pdf N1 - Author contact info: Bengt R. Holmstrom Department of Economics MIT E52-383A Cambridge, MA 02142 Tel: 617/253-0506 Fax: 617/253-1330 E-Mail: bengt@mit.edu Jean Tirole Institut d'Economie Industrielle Bureau MF529 - Bat. F 21 allees de Brienne 31000 Toulouse FRANCE Tel: 33-561-128642 E-Mail: tirole@cict.fr AB - This paper addresses a basic yet unresolved question: Do claims on private assets provide sufficient liquidity for an efficient functioning of the productive sector? Or does the State have a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means? In our model, firms can meet future liquidity needs in three ways: by issuing new claims and diluting old ones, by obtaining a credit credit line from a financial intermediary, and by holding claims on other firms. When there is no aggregate uncertainty, we show that these instruments are sufficient for attaining the socially optimal (second-best) contract between investors and firms. Such a contract imposes both a maximum leverage ratio and a liquidity constraint on firms. Intermediaries coordinate the use of liquidity. Without intermediation, scarce liquidity may be wasted and the social optimum may not be attainable. When there is only aggregate uncertainty the private sector is no longer self-sufficient with regard to liquidity. The government can improve liquidity by issuing bonds that commit future consumer income. Government bonds command a liquidity premium over private claims. The supply of liquidity can be managed by loosening liquidity (boosting the value of its securities) when the aggregate liquidity shock is high and tightening liquidity when the shock is low. The paper thus provides a microeconomic example of government supplied liquidity as well as of the possibility of active government policy. ER -