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Central Banks and the Financial System

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  • Francesco Giavazzi
  • Alberto Giovannini

Abstract

Financial systems are inherently fragile because of the very function which makes them valuable: liquidity transformation. Regulatory reforms can strengthen the financial system and decrease the risk of liquidity crises, but they cannot eliminate it completely. This leaves monetary policy with a very important task. In a framework that recognizes the interactions between monetary policy and liquidity transformation 'optimal' monetary policy would consist of a modified Taylor rule in which the real rate reflects the possibility of liquidity crises and recognizes the possibility that liquidity transformation gets subsidized. Failure to recognize this point risks leading the economy into a low interest rate trap: low interest rates induce too much risk taking and increase the probability of crises. These crises, in turn, require low interest rates to maintain the financial system alive. Raising rates becomes extremely difficult in a severely weakened financial system, so monetary authorities remain stuck in a low interest rates trap. This seems a reasonable description of the situation we have experienced throughout the past decade.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16228.

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Date of creation: Jul 2010
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Publication status: published as “Central Banks and Financial System”, in S. Eijffinger and D. Masciandaro (eds.), Central Banking, Financial Regulation and Supervision After the Financial Crisis, Edward Elgar forthcoming. (with Alberto Giovannini)
Handle: RePEc:nbr:nberwo:16228

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Cited by:
  1. Jin Cao & Gerhard Illing, 2011. ""Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?," Working Paper, Norges Bank 2011/12, Norges Bank.
  2. Angelo Melino, 2011. "Moving Monetary Policy Forward: Why Small Steps - and a Lower Inflation Target - Make Sense for the Bank of Canada," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 319, January.
  3. Unknown, 2010. "Reform of the Global Financial Architecture," Working Papers, Bruegel 444, Bruegel.
  4. Cizkowicz, Piotr & Rzonca, Andrzej, 2011. "Interest rates close to zero, post-crisis restructuring and natural interest rate," MPRA Paper 36989, University Library of Munich, Germany.
  5. Kyungsoo Kim & Byoung-Ki Kim & Hail Park, 2011. "Monetary policy framework and financial procyclicality: international evidence," BIS Papers chapters, in: Bank for International Settlements (ed.), Macroprudential regulation and policy, volume 60, pages 51-57 Bank for International Settlements.

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