The cheapest way for banks to finance long term illiquid projects is typically to borrow short term from households. But when household needs for funds are high, interest rates will rise sharply, debtors will have to shut down illiquid projects, and in extremis, will face more damaging runs. Authorities may want to push down interest rates to maintain economic activity in the face of such illiquidity, but intervention may not always be feasible, and when feasible, could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off. Authorities may want to commit to a specific policy of interest rate intervention to restore appropriate incentives. For instance, to offset incentives for banks to make more illiquid loans, authorities may have to commit to raising rates when low, to counter the distortions created by lowering them when high. We draw implications for interest rate policy to combat illiquidity.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
15197.
Length: Date of creation: Jul 2009 Date of revision: Handle: RePEc:nbr:nberwo:15197
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Find related papers by JEL classification: E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies G01 - Financial Economics - - General - - - Financial Crises G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
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