Three essays on money and banking: effects of monetary policy on liquidity risk

This thesis studies the effects of monetary policy on liquidity risk. I extend the model of financial intermediation developed by Diamond and Dybvig (1983) to include a monetary authority. Through the lens of different versions of this model, I study the effects of negative interest on reserves, of payment of positive interest on reserves and of a large central-bank balance sheet. In the first essay, I study optimal monetary policy in the model’s liquidity trap. I find that a negative interest on reserves is effectively a tax on the banking system. As such, it leads to less effective financial intermediation and therefore increases liquidity risk. On the other hand, it also acts as a tax on saving and therefore has the effect of boosting aggregate demand. I find that in the liquidity trap, when aggregate demand is insufficient to absorb the economy’s full productive capacity, it is optimal for the central bank to set a strictly negative interest on bank reserves. The second essay adds financial markets to the model. Banks faced with competition for savings from financial markets are unable to fully insure depositors’ liquidity risk. In this setting, I ask whether appropriate monetary policy can improve the economy’s equilibrium outcome. I find that paying a positive interest on bank reserves is welfare improving. There exists a strictly positive level of interest on reserves that implements the economy’s efficient allocation. In the last essay, I make the model’s term structure of interest rates endogenous. I find that the central bank can control the term premium by varying the size of its balance sheet. In particular, issuing bank reserves lowers the return on long-term assets. I show that in this setting optimal monetary policy requires a large central-bank balance sheet.