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Amplification Mechanisms in Liquidity Crises

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Author Info
Arvind Krishnamurthy
Abstract

I describe two amplifications mechanisms that operate during liquidity crises and discuss the scope for central bank policies during crises as well as preventive policies in advance of crises. The first mechanism works through asset prices and balance sheets. A negative shock to the balance sheets of asset-holders causes them to liquidate assets, lowering prices, further deteriorating balance sheets, culminating in a crisis. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations lead agents to become uncertain about their investments causing them to disengage from markets and increase their demand for liquidity. This behavior leads to a loss of liquidity and a crisis.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15040.

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Date of creation: Jun 2009
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Handle: RePEc:nbr:nberwo:15040

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G01 - Financial Economics - - General - - - Financial Crises
G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
G2 - Financial Economics - - Financial Institutions and Services

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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Lasse Heje Pedersen, 2009. "When Everyone Runs for the Exit," NBER Working Papers 15297, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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