Liquidity Shortages and Monetary Policy

47 Pages Posted: 6 Feb 2008

See all articles by Jin Cao

Jin Cao

Ludwig Maximilian University of Munich (LMU); CESifo (Center for Economic Studies and Ifo Institute); Norges Bank - Research Department

Gerhard Illing

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: February 2008

Abstract

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.

Keywords: monetary policy, liquidity risk, financial stability

JEL Classification: E5, G21, G28

Suggested Citation

Cao, Jin and Illing, Gerhard, Liquidity Shortages and Monetary Policy (February 2008). CESifo Working Paper Series No. 2210. Available at SSRN: https://ssrn.com/abstract=1090825

Jin Cao

Ludwig Maximilian University of Munich (LMU) ( email )

Bankplassen 2, PB 1179 Sentrum
Oslo, NO-0107
Norway

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Norges Bank - Research Department ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Gerhard Illing (Contact Author)

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics ( email )

Ludwigstrasse 28
Munich, D-80539
Germany

HOME PAGE: http://www.sfm.vwl.uni-muenchen.de/

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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