## Liquidity Choice and Misallocation of Credit

_IMF Working Papers, December 20, 2019_

## Source details

**Canonical URL:** [Liquidity Choice and Misallocation of Credit](https://www.imf.org/en/publications/wp/issues/2019/12/20/liquidity-choice-and-misallocation-of-credit-48850)

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## Bibliographic details
- Authors: Ehsan Ebrahimy
- Published: December 20, 2019
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513521480.001

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### Summary
- 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.

### Key findings and mechanisms
- 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.

### Policy recommendations and scenarios
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2019/12/20/liquidity-choice-and-misallocation-of-credit-48850_