|Cao, Jin; Illing, Gerhard (2008): Liquidity shortages and monetary policy. CESifo Working Paper, 2210|
This is the latest version of this item.
The paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting 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. In that case, liquidity injection will make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. We show that unconditional free lending against good collateral, as suggested by the Bagehot Rule, fails to address the moral hazard problem: Even though we consider a model with pure illiquidity risk, it turns out that such a policy will encourage banks to behave naughty, providing insufficient level of liquidity.
|Item Type:||Paper (Discussion Paper)|
Economics > Chairs > Seminar for Macroeconomics
|Subjects:||300 Social sciences > 330 Economics|
|Deposited On:||15. Apr 2014 08:55|
|Last Modified:||29. Apr 2016 09:17|
Available Versions of this Item
Liquidity Shortages and Monetary Policy. (deposited 05. Aug 2007)
- Liquidity shortages and monetary policy. (deposited 15. Apr 2014 08:55) [Currently Displayed]