Liquidity Shortages and Monetary Policy
AbstractThe paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. In that case, liquidity injection will make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. We show that unconditional free lending against good collateral, as suggested by the Bagehot Rule, fails to address the moral hazard problem: Even though we consider a model with pure illiquidity risk, it turns out that such a policy will encourage banks to behave naughty, providing insufficient level of liquidity.
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Bibliographic InfoPaper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2210.
Date of creation: 2008
Date of revision:
monetary policy; liquidity risk; financial stability;
Other versions of this item:
- Illing, Gerhard & Cao, Jin, 2007. "Liquidity Shortages and Monetary Policy," Discussion Papers in Economics, University of Munich, Department of Economics 2008, University of Munich, Department of Economics.
- E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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- Nikolaou, Kleopatra, 2009. "Liquidity (risk) concepts: definitions and interactions," Working Paper Series, European Central Bank 1008, European Central Bank.
- Cao, Jin & Illing, Gerhard, 2008.
"Endogenous Systemic Liquidity Risk,"
Discussion Papers in Economics, University of Munich, Department of Economics
3358, University of Munich, Department of Economics.
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