A model to analyse financial fragility
AbstractOur purpose in this paper is to produce a tractable model which illuminates problems relating to individual bank behaviour and risk-taking, to possible contagious interrelationships between banks, and to the appropriate design of prudential requirements and incentives to limit ‘excessive’ risk-taking. Our model is rich enough to include heterogenous agents (commercial banks and investors), endogenous default, and multiple commodity, and credit and deposit markets. Yet, it is simple enough to be effectively computable. Financial fragility emerges naturally as an equilibrium phenomenon. In our model a version of the liquidity trap can occur. Moreover, the Modigliani-Miller proposition fails either through frictions in the (nominal) financial system or through incentives, arising from the imposed capital requirements, for differential investment behaviour because of capital requirements. In addition, a non-trivial quantity theory of money is derived, liquidity and default premia co-determine interest rates, and both regulatory and monetary policies have non-neutral effects. The model also indicates how monetary policy may affect financial fragility, thus highlighting the trade-off between financial stability and economic efficiency.
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Bibliographic InfoPaper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24703.
Length: 34 pages
Date of creation: Apr 2004
Date of revision:
Other versions of this item:
- Charles A.E. Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2003. "A Model to Analyse Financial Fragility," OFRC Working Papers Series 2003fe13, Oxford Financial Research Centre.
- Dimitrios P Tsomocos & Charles A.E. Goodhart, 2003. "A Model to Analyse Financial Fragility," Economics Series Working Papers 2003-FE-13, University of Oxford, Department of Economics.
- F3 - International Economics - - International Finance
- G3 - Financial Economics - - Corporate Finance and Governance
- J1 - Labor and Demographic Economics - - Demographic Economics
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- Tsomocos, Dimitrios P., 2003.
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- Dimitrios P Tsomocos, 2000. "Equilibrium Analysis, Banking and Financial Instability," Economics Series Working Papers 2003-FE-08, University of Oxford, Department of Economics.
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- Charles Goodhart, 1989. "Money, Information and Uncertainty: 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262071223, December.
- Tomoyuki Nakajima & Herakles Polemarchakis, 2005. "Money and Prices Under Uncertainty," Review of Economic Studies, Oxford University Press, vol. 72(1), pages 223-246.
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