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Endogenous Credit Cycles

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    Abstract

    We build a model in which verifiability of private debts, timing mismatch in debt settlements and borrowing leverage lead to liquidity crisis in the financial market. Central bank can respond to the liquidity crisis by adopting an unconventional monetary policy that resembles repurchase agreements between the central bank and the lenders. This policy is effective if the timing mismatch is nominal (i.e., a settlement participation risk). It is ineffective if the timing mismatch is driven by a real shock (i.e., preference shock).

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    File URL: http://economics.missouri.edu/working-papers/2011/WP1114_gu_haslag.pdf
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    Bibliographic Info

    Paper provided by Department of Economics, University of Missouri in its series Working Papers with number 1114.

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    Length: 28 pgs.
    Date of creation: 22 Sep 2011
    Date of revision:
    Handle: RePEc:umc:wpaper:1114

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    Keywords: liquidity problem; timing mismatch; leveraging; liquidity shock; settlement risk; repurchase agreement; consumption shock;

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    1. Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996. "Currency Elasticity and Banking Panics: Theory and Evidence," Canadian Journal of Economics, Canadian Economics Association, vol. 29(4), pages 828-64, November.
    2. Viral V. Acharya & S. Viswanathan, 2011. "Leverage, Moral Hazard, and Liquidity," Journal of Finance, American Finance Association, vol. 66(1), pages 99-138, 02.
    3. Orphanides, Athanasios, 2002. "Comment on the Conduct of Monetary Policy with a Shrinking Stock of Government Debt," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(3), pages 883-86, August.
    4. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
    5. Robert E. Hall, 2011. "The High Sensitivity of Economic Activity to Financial Frictions," Economic Journal, Royal Economic Society, vol. 121(552), pages 351-378, 05.
    6. Schreft, Stacey L & Smith, Bruce D, 2002. "The Conduct of Monetary Policy with a Shrinking Stock of Government Debt," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(3), pages 848-82, August.
    7. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
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