A New Keynesian Preferred Habitat Model with Repo (JMP)
This paper documents puzzling discrepancies in the Treasury cash and repo markets during the GFC and Covid-19. To explain these empirical observations, I develop a New Keynesian Preferred Habitat model that features market segmentation, financial frictions, and quality preference. I demonstrate a flight-to-liquidity demand for short-term Treasuries during the GFC, but a flight-from-safety supply for long-term Treasuries during Covid-19, emphasizing the role of (in)convenience yields during market distress. The model also verifies that repo rates are more ``risk-free” as they contain no price risk premia. Financial frictions reduce the transmission of conventional policy but enhance the effectiveness of QE. Additionally, the efficacy of monetary policies depends on the relative importance of the repo borrowing channel versus the cash borrowing channel. Overall, the results highlight the strong linkage between financial frictions and the real economy.