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Illiquidity and Interest Rate Policy

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  • Douglas W. Diamond
  • Raghuram G. Rajan

Abstract

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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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15197.

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Date of creation: Jul 2009
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Publication status: published as "Illiquid Banks, Financial Stability, and Interest Rate Policy" (with Raghuram G. Rajan), Journal of Political Economy, June 2012.
Handle: RePEc:nbr:nberwo:15197

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  1. Xavier Freixas & Antoine Martin & David Skeie, 2011. "Bank Liquidity, Interbank Markets, and Monetary Policy," Review of Financial Studies, Society for Financial Studies, vol. 24(8), pages 2656-2692.
  2. Douglas W. Diamond & Raghuram G. Rajan, 2009. "The Credit Crisis: Conjectures about Causes and Remedies," American Economic Review, American Economic Association, vol. 99(2), pages 606-10, May.
  3. Jean Tirole & Emmanuel Farhi, 2010. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," 2010 Meeting Papers 822, Society for Economic Dynamics.
  4. Hellwig, Martin, 1994. "Liquidity provision, banking, and the allocation of interest rate risk," European Economic Review, Elsevier, vol. 38(7), pages 1363-1389, August.
  5. Shin, Hyun Song & Adrian, Tobias, 2008. "Financial intermediaries, financial stability and monetary policy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 287-334.
  6. Kashyap, Anil K. & Rajan, Raghuram G. & Stein, Jeremy C., 2008. "Rethinking capital regulation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 431-471.
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