We 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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Paper provided by European University Institute in its series Economics Working Papers with number
ECO2009/09.
Length: Date of creation: 2009 Date of revision: Handle: RePEc:eui:euiwps:eco2009/09
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