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Macro-prudential Policy on Liquidity: What Does a DSGE Model Tell Us?

The financial crisis has led to the development of an active debate on the use of macro-prudential instruments for regulating the banking system, in particular for liquidity and capital holdings. Within the context of a micro-founded macroeconomic model, we allow commercial banks to choose their optimal mix of asset creation, apportioning this to either reserves or private sector loans. We examine the implications for quantities, relative non-financial and financial prices from standard macroeconomic shocks alongside shocks to the expected liquidity of banks and to the efficiency of the banking sector. We focus on the response by the monetary sector, in particular the optimal reserve-deposit ratio adopted by commercial banks. Overall we find some rationale for Basel III in providing commercial banks with an incentive to hold liquid assets, such as reserves, as this acts to limit the procyclicality of lending to the private sector.

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Paper provided by Tor Vergata University, CEIS in its series CEIS Research Paper with number 193.

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Length: 41 pages
Date of creation: 02 May 2011
Date of revision: 02 May 2011
Handle: RePEc:rtv:ceisrp:193
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  1. King, Robert G & Watson, Mark W, 1998. "The Solution of Singular Linear Difference Systems under Rational Expectations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1015-26, November.
  2. Scott Freeman & Joseph H. Haslag, 1993. "On the optimality of interest-bearing reserves in economies of overlapping generations," Research Paper 9328, Federal Reserve Bank of Dallas.
  3. Sargent, Thomas & Wallace, Neil, 1985. "Interest on reserves," Journal of Monetary Economics, Elsevier, vol. 15(3), pages 279-290, May.
  4. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
  5. Robert E. Hall, 1999. "Controlling the Price Level," NBER Working Papers 6914, National Bureau of Economic Research, Inc.
  6. Smith, Bruce D, 1991. "Interest on Reserves and Sunspot Equilibria: Friedman's Proposal Reconsidered," Review of Economic Studies, Wiley Blackwell, vol. 58(1), pages 93-105, January.
  7. Goodfriend, Marvin & McCallum, Bennett T., 2007. "Banking and interest rates in monetary policy analysis: A quantitative exploration," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1480-1507, July.
  8. Baltensperger, Ernst, 1980. "Alternative approaches to the theory of the banking firm," Journal of Monetary Economics, Elsevier, vol. 6(1), pages 1-37, January.
  9. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  10. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity, monetary policy, and financial cycles," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 14(Jan).
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