Liquidity Risk and Monetary Policy

Sauer, Stephan (August 2007): Liquidity Risk and Monetary Policy. Discussion Papers in Economics 2007-27

Abstract

This paper provides a framework to analyse emergency liquidity assistance of central banks on financial markets in response to aggregate and idiosyncratic liquidity shocks. The model combines the microeconomic view of liquidity as the ability to sell assets quickly and at low costs and the macroeconomic view of liquidity as a medium of exchange that influences the aggregate price level of goods. The central bank faces a trade-off between limiting the negative output effects of dramatic asset price declines and more inflation. Furthermore, the anticipation of central bank intervention causes a moral hazard effect with investors. This gives rise to the possibility of an optimal monetary policy under commitment.

• Item Type: Paper (Discussion Paper)
• Keywords: Liquidity shocks, Financial crises, Liquidity provision principle, Greenspan put, Optimal monetary policy intervention
• 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: E58, E44, G18
• Language: English