Interbank Market Liquidity and Central Bank Intervention
AbstractWe develop a simple model of the interbank market where banks trade a long term, safe asset. We show that when there is a lack of opportunities for banks to hedge aggregate and idiosyncratic liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. The model shows also that market freezes, where banks stop trading with each other, can be a feature of the constrained efficient allocation if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand.
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Bibliographic InfoPaper provided by European University Institute in its series Economics Working Papers with number ECO2009/09.
Date of creation: 2009
Date of revision:
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interbank market; liquidity; central bank intervention; open market operations;
Other versions of this item:
- Allen, Franklin & Carletti, Elena & Gale, Douglas, 2009. "Interbank market liquidity and central bank intervention," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 639-652, July.
- G01 - Financial Economics - - General - - - Financial Crises
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-02-28 (All new papers)
- NEP-BAN-2009-02-28 (Banking)
- NEP-CBA-2009-02-28 (Central Banking)
- NEP-MON-2009-02-28 (Monetary Economics)
- NEP-MST-2009-02-28 (Market Microstructure)
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