DP15827 Speculative and Precautionary Demand for Liquidity in Competitive Banking Markets
In standard models a preference for liquidity arises because investors want to take precautions against sudden expenditure needs. We propose that investors may also want to preserve flexibility in case better investment opportunities arrive later. The co-existence of both investor types is crucial for the scope and limits of bank liquidity creation. Co-existence can entail welfare gains in a friction-free world. However, when standard financial frictions apply, co-existence can result in welfare losses relative to a world with only a single investor type. In either case, policy recommendations based only on a single motive for liquidity demand may be seriously misguided.