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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. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
    2. Jürgen Eichberger & Martin Summer, 2005. "Bank Capital, Liquidity, and Systemic Risk," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 547-555, 04/05.
    3. Milgrom, Paul & Roberts, John, 1994. "Comparing Equilibria," American Economic Review, American Economic Association, vol. 84(3), pages 441-59, June.
    4. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters, in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc.
    5. 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.
    6. Edward M. Gramlich, 2005. "The importance of raising national saving : a speech at the Benjamin Rush Lecture, Dickinson College, Pennsylvania, March 2, 2005," Speech, Board of Governors of the Federal Reserve System (U.S.).
    7. 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.
    8. Upper, Christian & Worms, Andreas, 2002. "Estimating Bilateral Exposures in the German Interbank Market: Is there a Danger of Contagion?," Discussion Paper Series 1: Economic Studies 2002,09, Deutsche Bundesbank, Research Centre.
    9. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
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