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Macro-prudential Policy on Liquidity: What does a DSGE Model tell us?

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  • Jagjit S. Chadha

    ()

  • Luisa Corrado

    ()

Abstract

The financial crisis has led to the development of an active debate on the use of macro-prudential instruments for regulating the banking system, in particular for liquidity and capital holdings. Within the context of a micro-founded macroeconomic model, we allow commercial banks to choose their optimal mix of assets, apportioning these either to reserves or private sector loans. We examine the implications for quantities, relative non-financial and financial prices from standard macroeconomic shocks alongside shocks to the expected liquidity of banks and to the efficiency of the banking sector. We focus on the response by the monetary sector, in particular the optimal reserve-deposit ratio adopted by commercial banks over the business cycle. Overall we find some rationale for Basel III in providing commercial banks with an incentive to hold a greater stock of liquid assets, such as reserves, but also to provide incentives to increase the cyclical variation in reserves holdings as this acts to limit excessive procyclicality of lending to the private sector.

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File URL: ftp://ftp.ukc.ac.uk/pub/ejr/RePEc/ukc/ukcedp/1108.pdf
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Bibliographic Info

Paper provided by Department of Economics, University of Kent in its series Studies in Economics with number 1108.

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Date of creation: Apr 2011
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Handle: RePEc:ukc:ukcedp:1108

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Postal: Department of Economics, University of Kent at Canterbury, Canterbury, Kent, CT2 7NP
Phone: +44 (0)1227 764000
Fax: +44 (0)1227 827850
Web page: http://www.ukc.ac.uk/economics/

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Keywords: Liquidity; interest on reserves; policy instruments; Basel;

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Cited by:
  1. Jagjit S Chadha & Luisa Corrado & Jack Meaning, 2012. "Reserves, liquidity and money: an assessment of balance sheet policies," BIS Papers chapters, in: Bank for International Settlements (ed.), Are central bank balance sheets in Asia too large?, volume 66, pages 294-347 Bank for International Settlements.
  2. Jan Willem van den End, 2013. "A macroprudential approach to address liquidity risk with the Loan-to-Deposit ratio," DNB Working Papers 372, Netherlands Central Bank, Research Department.

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