Central Banks and the Financial System

23 Pages Posted: 28 Jul 2010

See all articles by Francesco Giavazzi

Francesco Giavazzi

National Bureau of Economic Research (NBER); University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER); Centre for Economic Policy Research (CEPR)

Giovannini Alberto

affiliation not provided to SSRN

Multiple version iconThere are 2 versions of this paper

Date Written: August 2010

Abstract

Financial systems are inherently fragile because of the very function which makes them valuable: liquidity transformation. Thus regulatory reforms, as urgent and desirable as they are, will definitely strengthen the financial system and decrease the risk of liquidity crises, but they will never eliminate it. This leaves monetary policy with a very important task. In a framework that recognizes the interactions between monetary policy and liquidity transformation 'optimal' monetary policy would consist of a modified Taylor rule in which the real rate reflects the possibility of liquidity crises and recognizes the possibility that liquidity transformation gets subsidized. Failure to recognize this point risks leading the economy into a low interest rate trap: low interest rates induce too much risk taking and increase the probability of crises. These crises, in turn, require low interest rates to maintain the financial system alive. Raising rates becomes extremely difficult in a severely weakened financial system, so monetary authorities remain stuck in a low interest rates trap. This seems a reasonable description of the situation we have experienced throughout the past decade.

Keywords: financial markets, monetray policy

JEL Classification: E4, E5

Suggested Citation

Giavazzi, Francesco and Giavazzi, Francesco and Alberto, Giovannini, Central Banks and the Financial System (August 2010). CEPR Discussion Paper No. DP7944, Available at SSRN: https://ssrn.com/abstract=1649892

Francesco Giavazzi (Contact Author)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Bocconi - Innocenzo Gasparini Institute for Economic Research (IGIER) ( email )

Via Roentgen 1
Milan, 20136
Italy
+39 02 5836 3304 (Phone)
+39 02 5836 3302 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Giovannini Alberto

affiliation not provided to SSRN ( email )

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
6
Abstract Views
1,233
PlumX Metrics