Equilibrium Effects of Liquidity Constraints

This paper analyzes the relationship between collateralized short-term debt and asset prices.
Banks increasingly used short-term debt during the lending boom before the last financial crisis
(Shin [2009]). This caused distortions in the asset price and triggered the excessive asset growth
in the market. The increase in the short-term borrowing also raised the interconnectedness of
the financial institutions and led to systemic risk. In order to achieve a stable financial system,
the amount of short-term debt needs to be regulated. In this paper, I explore the welfare
effects of a regulatory quantity limit on short-term debt. The preliminary results show that a
quantity restriction on short-term borrowing is welfare improving during the expansion when
the investors are optimistic. However, it is welfare decreasing during the recession when the
investors are pessimistic. Therefore, the regulatory limit on short-term borrowing should be
counter-cyclical: lower during expansions and higher during recessions.