Financial Amplification Mechanisms and the Federal Reserve's Supply of Liquidity During the Crisis

20 Pages Posted: 17 Sep 2010

See all articles by Asani Sarkar

Asani Sarkar

Federal Reserve Bank of New York

Jeffrey Shrader

Columbia University - School of International & Public Affairs (SIPA)

Date Written: August 1, 2010

Abstract

The small decline in the value of mortgage-related assets relative to the large total losses associated with the financial crisis suggests the presence of financial amplification mechanisms, which allow relatively small shocks to propagate through the financial system. We review the literature on financial amplification mechanisms and discuss the Federal Reserve’s interventions during different stages of the crisis in light of this literature. We interpret the Fed’s early-stage liquidity programs as working to dampen balance sheet amplifications arising from the positive feedback between financial constraints and asset prices. By comparison, the Fed’s later-stage crisis programs take into account adverse-selection amplifications that operate via increases in credit risk and the externality imposed by risky borrowers on safe ones. Finally, we provide new empirical evidence that increases in the Federal Reserve’s liquidity supply reduce interest rates during periods of high liquidity risk. Our analysis has implications for the impact on market prices of a potential withdrawal of liquidity supply by the Fed.

Keywords: Financial Amplification Mechanism, Federal Reserve Liquidity Facilities, Balance Sheet, Adverse Selection, Funding Liquidity, Market Liquidity

JEL Classification: G01, G18, G21, G32

Suggested Citation

Sarkar, Asani and Shrader, Jeffrey, Financial Amplification Mechanisms and the Federal Reserve's Supply of Liquidity During the Crisis (August 1, 2010). Economic Policy Review, Vol. 16, No. 1, p. 55, August 2010, FRB of New York Staff Report No. 431, Available at SSRN: https://ssrn.com/abstract=1678169 or http://dx.doi.org/10.2139/ssrn.1678169

Asani Sarkar (Contact Author)

Federal Reserve Bank of New York ( email )

Research Department
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New York, NY 10045
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212-720-8943 (Phone)
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HOME PAGE: http://www.newyorkfed.org/research/economists/sarkar/pub.html

Jeffrey Shrader

Columbia University - School of International & Public Affairs (SIPA) ( email )

420 West 118th Street
New York, NY 10027
United States

HOME PAGE: http://jeffreyshrader.com

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