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Amplification Mechanisms in Liquidity Crises

  • Arvind Krishnamurthy
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    I describe two amplifications mechanisms that operate during liquidity crises and discuss the scope for central bank policies during crises as well as preventive policies in advance of crises. The first mechanism works through asset prices and balance sheets. A negative shock to the balance sheets of asset-holders causes them to liquidate assets, lowering prices, further deteriorating balance sheets, culminating in a crisis. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations lead agents to become uncertain about their investments causing them to disengage from markets and increase their demand for liquidity. This behavior leads to a loss of liquidity and a crisis.

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    File URL: http://www.nber.org/papers/w15040.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15040.

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    Date of creation: Jun 2009
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    Publication status: published as Arvind Krishnamurthy, 2010. "Amplification Mechanisms in Liquidity Crises," American Economic Journal: Macroeconomics, vol 2(3), pages 1-30.
    Handle: RePEc:nbr:nberwo:15040
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