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

  • Ghossoub, Edgar A.
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    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.

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    Article provided by Elsevier in its journal European Economic Review.

    Volume (Year): 56 (2012)
    Issue (Month): 2 ()
    Pages: 155-173

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    Handle: RePEc:eee:eecrev:v:56:y:2012:i:2:p:155-173
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