Banking and Markets in a Monetary Model ∗ Gaetano Antinolfi † and Enrique Kawamura ‡ November 2, 2004 Abstract We model a dynamic economy in which two types of aggregate shocks are present. A liquidity shock affecting the demand for real balances, and a real shock affecting the outcome of investment. Banks arise to insure depositors against liquidity risk, which is by nature in- tertemporal. Markets provide insurance against the risk induced by real shocks, which, unlike liquidity shocks, determine the total amount of resources available in the economy at a given time. We study how the demand for liquididy of banks interacts with asset prices and inter- est rates in different institutional settings. We show that the economy in which banks, markets, and a central bank are present reaches the same equilibrium of an economy with complete asset markets and a safe asset, and that this is the only case leading to a Pareto optimal equilibrium. * For helpful conversations, we would like to thank, without implicating for any short- coming, Costas Azariadis, Abhijit Banerjee, Mart´ ın Gonz´ alez Eiras, Paula Hernandez, Jim Peck, Rob Reed, Paolo Siconolfi, Steve Spear, Anne Villamil, Ping Wang, as well as participants at several universities and conferences where this paper was presented. We gratefully acknowledge financial support from the Weidenbaum Center on the Economy, Government, and Public Policy at Washington University. † Department of Economics, Washington University, St. Louis MO 63130-4899, U.S.A., email, gaetano@wueconc.wustl.edu. ‡ Department of Economics, Universidad de San Andr´ es, Victoria (1644) Buenos Aires, Argentina, email: kawa@udesa.edu.ar. 1