Optimal Pricing
of Intra-Day Liquidity
By Antoine Martin
May 2002; Last Revised February 2003
RWP 02-02
Research Division
Federal Reserve Bank of Kansas City
Abstract
This paper presents a general equilibrium model where intraday liquidity is needed because the timing of payments is uncertain. A necessary and sufficient condition for an equilibrium to be efficient is that the nominal intraday interest rate be zero, even when the overnight rate is strictly positive. Because a market for liquidity may not achieve efficiency, this creates a role for the central bank. I allow for the possibility of moral hazard and study policies commonly used by central banks to reduce their exposure to risk. I show that collateralized lending achieves the efficient allocation, while, for certain parameters, caps cannot prevent moral hazard.
Keywords: Liquidity Provision, Intraday Interest Rate; Moral Hazard
JEL Codes: E42; E58; G21
Antoine Martin is an economist at the Federal Reserve Bank of Kansas City. He would like to thank Ed Green for getting him interested in the topic. He also thanks Michael Orlando, Will Roberds, Stacey Schreft, and seminar participants at Kansas University, the University of Missouri, and the Federal Reserve Bank of Minneapolis for useful comments.The views expressed in this paper are solely those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.
Martin e-mail: antoine.martin@kc.frb.org