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Liquidity Shortages and Monetary Policy

Author

Listed:
  • Illing, Gerhard
  • Cao, Jin

Abstract

The paper models the interaction between risk taking in the financial sector and central bank policy. It shows that in the absence of central bank intervention, the incentive of financial intermediaries to free ride on liquidity in good states may result 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. It is shown that public provision of liquidity improves the allocation, even though it encourages more risk taking (less liquid investment) by private banks.

Suggested Citation

  • Illing, Gerhard & Cao, Jin, 2007. "Liquidity Shortages and Monetary Policy," Discussion Papers in Economics 2008, University of Munich, Department of Economics.
  • Handle: RePEc:lmu:muenec:2008
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    File URL: https://epub.ub.uni-muenchen.de/2008/1/Cao_Illing.pdf
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    Cited by:

    1. 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.
    2. Cao, Jin & Illing, Gerhard, 2008. "Endogenous systemic liquidity risk," CFS Working Paper Series 2008/23, Center for Financial Studies (CFS).
    3. Nikolaou, Kleopatra, 2009. "Liquidity (risk) concepts: definitions and interactions," Working Paper Series 1008, European Central Bank.

    More about this item

    Keywords

    Liquidity Provision; Monetary Policy; Bank Runs;

    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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