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Liquidity Shortages and Monetary Policy

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  • Illing, Gerhard
  • Cao, Jin
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Abstract

The paper models the interaction between risk taking in the financial sector and central bank policy. It shows that in the absence of central bank intervention, the incentive of financial intermediaries to free ride on liquidity in good states may result 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. It is shown that public provision of liquidity improves the allocation, even though it encourages more risk taking (less liquid investment) by private banks.

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File URL: http://epub.ub.uni-muenchen.de/2008/1/Cao_Illing.pdf
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Bibliographic Info

Paper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 2008.

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Date of creation: Jul 2007
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Handle: RePEc:lmu:muenec:2008

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Keywords: Liquidity Provision; Monetary Policy; Bank Runs;

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Cited by:
  1. Jin Cao & Gerhard Illing, 2009. "Endogenous Systemic Liquidity Risk," CESifo Working Paper Series 2627, CESifo Group Munich.
  2. Nikolaou, Kleopatra, 2009. "Liquidity (risk) concepts: definitions and interactions," Working Paper Series 1008, European Central Bank.

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