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Liquidity risk and financial competition: Implications for asset prices and monetary policy

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  • Ghossoub, Edgar A.

Abstract

This paper studies the implications of banking competition for capital markets and monetary policy. In particular, I develop a two-sector monetary growth model in which a group of agents is exposed to liquidity shocks and money is essential. Banks insure depositors against such risk and invest in the economy's assets. In this setting, I compare an economy with a perfectly competitive banking sector to an economy with a fully concentrated financial sector. Unlike previous work, banks can have market power in both deposits and capital markets. Compared to a perfectly competitive financial sector, I demonstrate that a monopolistic banking system can have substantial adverse consequences on capital formation, assets prices, and the degree of risk sharing. Furthermore, multiple steady-states can emerge and the economy becomes subject to poverty traps. More importantly, market power in financial markets may overturn the Tobin effect present under a perfectly competitive financial sector. This necessarily happens in economies with high degrees of liquidity risk and low levels of capital formation.

Suggested Citation

  • Ghossoub, Edgar A., 2012. "Liquidity risk and financial competition: Implications for asset prices and monetary policy," European Economic Review, Elsevier, vol. 56(2), pages 155-173.
  • Handle: RePEc:eee:eecrev:v:56:y:2012:i:2:p:155-173
    DOI: 10.1016/j.euroecorev.2011.09.006
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    Keywords

    Financial competition; Monetary policy; Financial intermediation; Liquidity risk;

    JEL classification:

    • O42 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Monetary Growth Models
    • D42 - Microeconomics - - Market Structure, Pricing, and Design - - - Monopoly
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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