Liquidity Shortages and Monetary Policy

Illing, Gerhard and Cao, Jin (July 2007): Liquidity Shortages and Monetary Policy. Discussion Papers in Economics 2007-25

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.

• Item Type: Paper (Discussion Paper)
• Keywords: Liquidity Provision, Monetary Policy, Bank Runs
• Subjects: Economics; Economics > Discussion Papers in Economics; Economics > Discussion Papers in Economics > Macro-Economics
• Dewey Classification: 300 Social sciences; 300 Social sciences > 330 Wirtschaft
• Journal of Economic Literature classification: E5, G21, G28
• Language: English