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Financial amplification mechanisms and the Federal Reserve's supply of liquidity during the crisis

  • Asani Sarkar
  • Jeffrey Shrader

The small decline in the value of mortgage-related assets relative to the large total losses associated with the financial crisis suggests the presence of financial amplification mechanisms, which allow relatively small shocks to propagate through the financial system. We review the literature on financial amplification mechanisms and discuss the Federal Reserve's interventions during different stages of the crisis in light of this literature. We interpret the Fed's early-stage liquidity programs as working to dampen balance sheet amplifications arising from the positive feedback between financial constraints and asset prices. By comparison, the Fed's later-stage crisis programs take into account adverse-selection amplifications that operate via increases in credit risk and the externality imposed by risky borrowers on safe ones. Finally, we provide new empirical evidence that increases in the Federal Reserve's liquidity supply reduce interest rates during periods of high liquidity risk. Our analysis has implications for the impact on market prices of a potential withdrawal of liquidity supply by the Fed.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 431.

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Date of creation: 2010
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Handle: RePEc:fip:fednsr:431
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  1. Nobuhiro Kiyotaki & Gauti Eggertsson & Andrea Ferrero & Marco Del Negro, 2010. "The Great Escape? A Quantitative Evaluation of the Fed’s Non-Standard Policies," 2010 Meeting Papers 113, Society for Economic Dynamics.
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