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Financial Stability and Monetary Policy – A Framework

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  • Gerhard Illing
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    Abstract

    The paper presents a stylised framework to analyse conditions under which monetary policy contributes to amplified movements in the housing market. Extending work by Hyun Shin (2005), the paper analyses self enforcing feedback mechanisms resulting in amplifier effects in a credit constrained economy. The paper characterizes conditions for asymmetric effects, causing systemic crises. By injecting liquidity, monetary policy can prevent a meltdown. Anticipating such a response, private agents are encouraged to take higher risks. Provision of liquidity works as a public good, but it may create potential conflicts with other policy objectives and may give incentives to build up leverage with a high systemic exposure to small probability events.

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    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2007/wp-cesifo-2007-04/cesifo1_wp1971.pdf
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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1971.

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    Date of creation: 2007
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    Handle: RePEc:ces:ceswps:_1971

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    1. Milgrom, Paul & Roberts, John, 1994. "Comparing Equilibria," American Economic Review, American Economic Association, vol. 84(3), pages 441-59, June.
    2. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
    3. Upper, Christian & Worms, Andreas, 2004. "Estimating bilateral exposures in the German interbank market: Is there a danger of contagion?," European Economic Review, Elsevier, vol. 48(4), pages 827-849, August.
    4. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    5. Illing, Gerhard, 1992. "Private Information as Transaction Costs: The Coase Theorem Revisited," Munich Reprints in Economics 19522, University of Munich, Department of Economics.
    6. Juergen Eichberger & Martin Summer, 2004. "Bank Capital, Liquidity and Systemic Risk," Working Papers 87, Oesterreichische Nationalbank (Austrian Central Bank).
    7. Franke, Günter & Krahnen, Jan Pieter, 2005. "Default risk sharing between banks and markets: The contribution of collateralized debt obligations," CFS Working Paper Series 2005/06, Center for Financial Studies (CFS).
    8. Martin Hellwig, 1998. "Financial Institutions in Transition: Banks, Markets, and the Allocation of Risks in an Economy," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 154(1), pages 328-, March.
    9. Franklin Allen & Douglas Gale, 2005. "From Cash-in-the-Market Pricing to Financial Fragility," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 535-546, 04/05.
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