We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. The model accounts for the entire crisis cycle, matching data on the frothy precrisis behavior of asset markets and credit; the sharp transition to a crisis where asset values fall, disintermediation occurs, and output falls; and the slow postcrisis recovery in output. Both the intermediation and the belief mechanism are essential to match the crisis cycle. However, modeling the belief variation via either a Bayesian or a diagnostic model can match the broad patterns.

Investors value the liquidity and safety of US Treasuries. We document this by showing that changes in Treasury supply have large effects on a variety of yield spreads. As a result, Treasury yields are reduced by 73 basis points, on average, from 1926 to 2008. Both the liquidity and safety attributes of Treasuries are driving this phenomenon. We document this by analyzing the spread between assets with different liquidity (but similar safety) and those with different safety (but similar liquidity). The low yield on Treasuries due to their extreme safety and liquidity suggests that Treasuries in important respects are similar to money.