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Liquidity Crises, Banking, and the Great Recession

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  • Radde, Sören
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    Abstract

    This paper presents a dynamic stochastic general equilibrium model which studies the business-cycle implications of financial frictions and liquidity risk at the bank-level. Following Holmstr m and Tirole (1998), demand for liquidity reserves arises from the anticipation of idiosyncratic operating expenses during the execution phase of bank-financed investment projects. Banks react to adverse aggregate shocks by hoarding liquidity while being forced to decrease their leverage. Both effects amplify recessionary dynamics, since they crowd out funds available for investment financing. This mechanism is triggered by a market liquidity squeeze modelled as a shock to the collateral value of banks assets. This novel type of aggregate risk induces a credit crunch scenario which shares key features with the Great Recession such as strong output decline, pro-cyclical leverage and counter-cyclical liquidity hoarding. Unconventional credit policy in the form of a wealth transfer from households to credit constrained banks is shown to mitigate the credit crunch. --

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    Bibliographic Info

    Paper provided by Verein für Socialpolitik / German Economic Association in its series Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century with number 65408.

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    Date of creation: 2012
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    Handle: RePEc:zbw:vfsc12:65408

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