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Central Banks and the Financial System

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  • Giavazzi, Francesco
  • Giovannini, Alberto

Abstract

Financial systems are inherently fragile because of the very function which makes them valuable: liquidity transformation. Thus regulatory reforms, as urgent and desirable as they are, will definitely strengthen the financial system and decrease the risk of liquidity crises, but they will never eliminate it. This leaves monetary policy with a very important task. In a framework that recognizes the interactions between monetary policy and liquidity transformation 'optimal' monetary policy would consist of a modified Taylor rule in which the real rate reflects the possibility of liquidity crises and recognizes the possibility that liquidity transformation gets subsidized. Failure to recognize this point risks leading the economy into a low interest rate trap: low interest rates induce too much risk taking and increase the probability of crises. These crises, in turn, require low interest rates to maintain the financial system alive. Raising rates becomes extremely difficult in a severely weakened financial system, so monetary authorities remain stuck in a low interest rates trap. This seems a reasonable description of the situation we have experienced throughout the past decade

Suggested Citation

  • Giavazzi, Francesco & Giovannini, Alberto, 2010. "Central Banks and the Financial System," CEPR Discussion Papers 7944, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:7944
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    References listed on IDEAS

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    1. Jean Tirole, 2011. "Illiquidity and All Its Friends," Journal of Economic Literature, American Economic Association, vol. 49(2), pages 287-325, June.
    2. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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    Citations

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    Cited by:

    1. Jin Cao & Gerhard Illing, 2011. ""Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?," Working Paper 2011/12, Norges Bank.
    2. Piotr Ciżkowicz & Andrzej Rzońca, 2014. "Interest Rates Close to Zero, Post-crisis Restructuring and Natural Interest Rate," Prague Economic Papers, University of Economics, Prague, vol. 2014(3), pages 315-329.
    3. Badarau, Cristina & Popescu, Alexandra, 2014. "Monetary policy and credit cycles: A DSGE analysis," Economic Modelling, Elsevier, vol. 42(C), pages 301-312.
    4. Garry J. Schinasi & Edwin M. Truman, 2010. "Reform of the Global Financial Architecture," Working Paper Series WP10-14, Peterson Institute for International Economics.
    5. Angelo Melino, 2011. "Moving Monetary Policy Forward: Why Small Steps - and a Lower Inflation Target - Make Sense for the Bank of Canada," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 319, January.
    6. Kyungsoo Kim & Byoung-Ki Kim & Hail Park, 2011. "Monetary policy framework and financial procyclicality: international evidence," BIS Papers chapters,in: Bank for International Settlements (ed.), Macroprudential regulation and policy, volume 60, pages 51-57 Bank for International Settlements.
    7. Alin Marius ANDRIES & Vasile COCRIS & Ioana PLESCAU, 2015. "Low Interest Rates And Bank Risk-Taking: Has The Crisis Changed Anything? Evidence From The Eurozone," Review of Economic and Business Studies, Alexandru Ioan Cuza University, Faculty of Economics and Business Administration, issue 15, pages 125-148, June.

    More about this item

    Keywords

    financial markets; monetray policy;

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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