Liquidity Crises and the Market-Maker of Last Resort

We study market illiquidity in an economy subject to non-fundamental shocks. Asset trading occurs via decentralized one-on-one bargaining. The model has multiple rational expectations equilibria; we associate certain Pareto inferior equilibria with liquidity crises. The government can improve welfare by acting as a “market-maker of last resort” (MMLR), purchasing assets at above-market prices. Several policies employed by the US during the recent financial crisis are examples of MMLR. However, when we impose a restriction akin to a “no-bailout” constraint, we find that even the MMLR policy cannot support the unique Pareto optimal allocation as an equilibrium.