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Precautionary Liquidity Shocks, Excess Reserves and Business Cycles

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This paper identifies a precautionary banking liquidity shock via a set of sign, zero and forecast variance restrictions imposed. The shock proxies the reluctance of the banking sector to "lend" to the real economy induced by an exogenous change in financial intermediaries' preference for "high" liquid assets. The identified shock has sizeable and state (volatility) dependent effects on the real economy. To understand the transmission of the shock, we develop a DSGE model of financial intermediation with credit and liquidity frictions. The precautionary liquidity shock is shown to work through two channels: it increases the level of reserves and the deposit rate. The former is a balance sheet effect, which reduces the loan-to-deposit ratio. The higher deposit rate affects the intertemporal decisions of households and the cost of borrowing to firms. The overall effect is a downward co-movement in output, consumption, investment and prices, which is amplified the higher are the long-run risks in the economy and the responsiveness of banks to potential risk.

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  • Bratsiotis, George & Theodoridis, Konstantinos, 2020. "Precautionary Liquidity Shocks, Excess Reserves and Business Cycles," Cardiff Economics Working Papers E2020/15, Cardiff University, Cardiff Business School, Economics Section.
    • Handle: RePEc:cdf:wpaper:2020/15
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    2. Phuong Mai Le, Vo & Matthews, Kent & Meenagh, David & Minford, Patrick & Xiao, Zhiguo, 2022. "Regulatory arbitrage, shadow banking and monetary policy in China," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 80(C).

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    More about this item

    Keywords

    House Prices; SVAR; Sign and Zero Restrictions; DSGE; Precautionary Liquidity Shock; Excess Reserves; Deposit Rate; Risk; Financial Intermediation.;
    All these keywords.

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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