Angelo Ranaldo, Universität St. Gallen, Fragility of Money Markets
We provide the first comprehensive theoretical model for money markets encompassing unsecured and secured funding, asset markets, and central bank policy. Capital-constrained, leveraged banks invest in assets and raise short-term funds by borrowing in the unsecured and secured money markets. Our model derives how funding liquidity across money markets is related, explains how a shock to asset values can lead to mutually reinforcing liquidity spirals in both money markets, and shows how borrowers’ flight-to-safety and risk-seeking behavior impacts their liability structure. We derive the social optimum and show which combination of conventional and unconventional monetary policies and regulatory measures can reduce money market fragility.