Liquidity provision, interest rates, and unemployment

• The effective liquidity supply of the economy matters for interest rates and unemployment.
• Public liquidity crowds out private liquidity and increases unemployment.
• Scarce liquidity can be socially optimal to promote job creation.
• A flight to liquidity raises unemployment and rate-of-return differences across assets.

The effective liquidity supply of the economy—the weighted-sum of all assets that serve as media of exchange—matters for interest rates and unemployment. We formalize this idea by adding an over-the-counter market with collateralized trades to the Mortensen–Pissarides model. An increase in public liquidity through a higher supply of real government bonds raises the real interest rate, crowding out private liquidity and increasing unemployment. If unemployment is inefficiently high, keeping liquidity scarce can be socially optimal. A liquidity crisis affecting the acceptability of private assets as collateral widens the rate-of-return difference between private and public liquidity, also increasing unemployment.