Optimal intermediated investment in a liquidity-driven cycle

A general equilibrium model of a financial intermediary extends the one first introduced by Diamond and Dybvig to an infinite-horizon environment. As in the Diamond-Dybvig model, the bank is considered as an optimal financial intermediary coalition in the present work. With the enriched framework, we study how the bank adjusts its asset portfolio in response to a shock that affects the size of its liability. Analysis shows that the bank adjusts not only the supply of credit but also its liquidity composition. The results are qualitatively consistent with what we observe from the banking industry in the United States.