Banking and Markets in a Monetary Model

We model a dynamic economy in which two types of aggregate shocks are present. A liquidity shock a¤ecting the demand for real balances, and a real shock that a¤ecting the outcome of investment. Banks arise to insure depositors against liquidity risk, which is by nature intertemporal. Markets provide insurance against the risk in-duced by real shocks, which, unlike liquidity shocks, determine the total amount of resources available in the economy at a given time. We study how the demand for liquididy of banks interacts with asset prices and interest rates in di¤erent institutional settings. We show that the economy in which banks, markets, and a central bank are present reaches the same equilibrium of an economy with complete asset markets and a safe asset, and that this is the only case leading to a Pareto optimal equilibrium. For helpful conversations, we would like to thank, without implicating for any short