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Macro-prudential policy on liquidity: What does a DSGE model tell us?

  • Chadha, Jagjit S.
  • Corrado, Luisa

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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Article provided by Elsevier in its journal Journal of Economics and Business.

Volume (Year): 64 (2012)
Issue (Month): 1 ()
Pages: 37-62

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Handle: RePEc:eee:jebusi:v:64:y:2012:i:1:p:37-62
Contact details of provider: Web page: http://www.elsevier.com/locate/jeconbus

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  1. 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).
  2. Marvin Goodfriend & Bennett T. McCallum, 2007. "Banking and Interest Rates in Monetary Policy Analysis: A Quantitative Exploration," NBER Working Papers 13207, National Bureau of Economic Research, Inc.
  3. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  4. Robert E. Hall, 1999. "Controlling the Price Level," NBER Working Papers 6914, National Bureau of Economic Research, Inc.
  5. 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.
  6. 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.
  7. Sargent, Thomas & Wallace, Neil, 1985. "Interest on reserves," Journal of Monetary Economics, Elsevier, vol. 15(3), pages 279-290, May.
  8. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
  9. 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).
  10. Baltensperger, Ernst, 1980. "Alternative approaches to the theory of the banking firm," Journal of Monetary Economics, Elsevier, vol. 6(1), pages 1-37, January.
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