The Supply and Demand for Safe Assets

Safe assets are demanded to smooth consumption across states (both intertemporallyand in cross-section). Some of these assets are supplied publicly (governmentbonds) and some are created and supplied privately (such as mortgage-backedsecurities and asset-backed securities). Private assets are created endogenouslywhen the supply of government bonds is low. Private assets are used ascollateral and come in heterogeneous quality. Financial fragility is the probabilitythat a large amount of private assets are examined, some are found to be oflow quality and then some firms cannot get loans. We characterize the government'soptimal supply of government bonds when considering their effects onthe creation of private assets and on economy-wide fragility. We show that monetaryand macroprudential policies cannot be run in isolation. When there are toomany private assets the government should operate a Bond Exchange Facility thatexchanges private assets for public safe assets