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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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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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  1. Goodfriend, Marvin & McCallum, Bennett T., 2007. "Banking and interest rates in monetary policy analysis: A quantitative exploration," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1480-1507, July.
  2. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
  3. Smith, B.D., 1988. "Interest On Reserves And Sunspot Equilibria: Friedman'S Proposal Reconsidered," RCER Working Papers 119, University of Rochester - Center for Economic Research (RCER).
  4. Hall Robert, 2002. "Controlling the Price Level," The B.E. Journal of Macroeconomics, De Gruyter, vol. 2(1), pages 1-21, July.
  5. Scott Freeman & Joseph H. Haslag, 1996. "On the optimality of interest-bearing reserves in economies of overlapping generations (*)," Economic Theory, Springer, vol. 7(3), pages 557-565.
  6. Sargent, Thomas & Wallace, Neil, 1985. "Interest on reserves," Journal of Monetary Economics, Elsevier, vol. 15(3), pages 279-290, May.
  7. King, Robert G & Watson, Mark W, 1998. "The Solution of Singular Linear Difference Systems under Rational Expectations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1015-26, November.
  8. Baltensperger, Ernst, 1980. "Alternative approaches to the theory of the banking firm," Journal of Monetary Economics, Elsevier, vol. 6(1), pages 1-37, January.
  9. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  10. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity, monetary policy, and financial cycles," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 14(Jan).
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Citations

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Cited by:
  1. Jagjit S.Chadha & Elisa Newby, 2013. "'Midas, transmuting all, into paper': the Bank of England and the Banque de France during the Napoleonic Wars," Studies in Economics 1315, Department of Economics, University of Kent.
  2. de Haan, Leo & van den End, Jan Willem, 2013. "Bank liquidity, the maturity ladder, and regulation," Journal of Banking & Finance, Elsevier, vol. 37(10), pages 3930-3950.
  3. Jagjit S. Chadha & Luisa Corrado & Jack Meaning, 2012. "Reserves, Liquidity and Money: An Assessment of Balance sheet Policies," Studies in Economics 1208, Department of Economics, University of Kent.
  4. 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.
  5. Chadha , Jagjit S. & Newby, Elisa, 2013. "Midas, transmuting all, into paper: The Bank of England and the Banque de France during the Revolutionary and Napoleonic Wars," Research Discussion Papers 20/2013, Bank of Finland.
  6. Falagiarda, Matteo, 2013. "Evaluating Quantitative Easing: A DSGE Approach," MPRA Paper 49457, University Library of Munich, Germany.

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