Liquidity Choice and Misallocation of Credit

IMF Working Papers, December 20, 2019

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This paper studies a novel type of misallocation of credit between investments of varying liquidity.
One type of investment is more liquid, i.e., its return is more pledgeable, and the other is more productive.
Low liquidities of both investment types imply that the allocation of credit is constrained inefficient and that there is overinvestment in the liquid type.
Constrained inefficient equilibria feature non-positive, i.e., one less than or equal the economy’s growth rate, and yet too high interest rate, too much investment and too little consumption.
Financial development can reduce long-term welfare and output in a constrained inefficient equilibrium if it raises the liquidity of the liquid type.
A maximum liquid asset ratio or a simple debt tax can achieve constrained efficiency.
Introducing government bonds can make Pareto improvement whenever it does not raise the interest rate.

Misallocation arises from differing pledgeability (liquidity) and productivity across investment types.
Overinvestment in the liquid type occurs when both investment types have low liquidity.
Constrained inefficiency is characterized by:
- non-positive growth outcomes, described as "one less than or equal the economy’s growth rate"
- simultaneously too high interest rate
- too much investment
- too little consumption
Financial development is not unambiguously welfare-improving: if it increases liquidity of the liquid investment type, it can reduce long-term welfare and output in constrained inefficient equilibria.
Policy instruments shown to restore constrained efficiency include:
- a maximum liquid asset ratio
- a simple debt tax
Government bonds can deliver Pareto improvements conditional on not raising the interest rate.

Implement a maximum liquid asset ratio to constrain excessive allocation to liquid but less productive investments.
Consider a simple debt tax as an alternative instrument to achieve constrained efficiency.
Use government bonds to improve welfare provided issuance does not increase the interest rate.