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Liquidity Shortages and Monetary Policy

Author

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  • Jin Cao
  • Gerhard Illing

Abstract

The paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. In that case, liquidity injection will make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. We show that unconditional free lending against good collateral, as suggested by the Bagehot Rule, fails to address the moral hazard problem: Even though we consider a model with pure illiquidity risk, it turns out that such a policy will encourage banks to behave naughty, providing insufficient level of liquidity.

Suggested Citation

  • Jin Cao & Gerhard Illing, 2008. "Liquidity Shortages and Monetary Policy," CESifo Working Paper Series 2210, CESifo Group Munich.
  • Handle: RePEc:ces:ceswps:_2210
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    File URL: http://www.cesifo-group.de/DocDL/cesifo1_wp2210.pdf
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    Cited by:

    1. Cao, Jin & Illing, Gerhard, 2008. "Endogenous systemic liquidity risk," CFS Working Paper Series 2008/23, Center for Financial Studies (CFS).
    2. Nikolaou, Kleopatra, 2009. "Liquidity (risk) concepts: definitions and interactions," Working Paper Series 1008, European Central Bank.
    3. Nicolas Moumni & Benaissa Nahhal, 2014. "Impact of Liquidity Level on the Monetary Policy Transmission Effectiveness of the Moroccan Central Bank (Bank Al Maghrib)," International Journal of Economics and Financial Issues, Econjournals, vol. 4(4), pages 801-818.

    More about this item

    Keywords

    monetary policy; liquidity risk; financial stability;

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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