Center for Quantitative Economic Research

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Liquidity Needs in Economies with Interconnected Financial Obligations

Julio J. Rotemberg
CQER Working Paper 09-01
July 2009

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A model is developed in which firms in a financial system have to settle their debts to each other by using a liquid asset (or money). The question studied is how many firms must have access to this asset from outside the financial system to make sure that all debts within the system are settled. The main result is that these liquidity needs are larger when these firms are more interconnected through their debts, that is, when they borrow from and lend to more firms. Two pecuniary externalities are discussed. One is the result of paying one creditor first rather than another. The second occurs when firms increase their financial transactions and thereby make it more likely that others will default. Finally, the paper shows that interconnections can raise the number of firms that must be endowed with liquidity even when payments paths are chosen by a planner that seeks to avoid defaults.

JEL classification: G20, D53, D85

Key words: liquidity, settlement, interconnected companies

The author thanks seminar participants at the University of Houston, Brandeis University, MIT, and the Federal Reserve Bank of Atlanta as well as Stephen Cecchetti, Pablo Kurlat, Ivan Werning, and Michael Woodford for comments. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.

Please address questions regarding content to Julio J. Rotemberg, Harvard Business School, Soldiers Field, Boston, MA 02163, 617-495-1015,