This paper studies how Treasury market dynamics depend on adjustments to the central bank balance sheet. We introduce a dynamic model of Treasury bonds with traditional and shadow banks. In the model, both Treasury and repo market disruptions arise as a joint consequence of three frictions: (i) balance sheet costs,(ii) intraday reserves requirements, and (iii) imperfect substitutability between repo and bank deposits. Our model highlights the critical role of both sides of the central bank’s balance sheet as well as agents’ anticipation of shocks and policy interventions in matching observed market dynamics.
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