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.