Amplification Mechanisms in Liquidity Crises

Amplification Mechanisms in Liquidity Crises Abstract I describe two amplifications mechanisms that operate during crises and discuss the benefits of policy given each mechanism. The first mechanism involves asset prices and balance sheets. A negative shock to agents' balance sheets causes them to liquidate assets, lowering prices, further deteriorating balance sheets and amplifying the shock. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations increase agents' uncertainty about their investments, causing them to disengage from markets and amplifying the crisis. Liquidity provision by the central bank alleviates the crisis in both mechanisms. Ex ante policies such as liquidity/capital requirements may also be beneficial. (JEL E32, E44, G01, G21, G32 ) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Journal: Macroeconomics American Economic Association

Amplification Mechanisms in Liquidity Crises

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Publisher
American Economic Association
Copyright
Copyright © 2010 by the American Economic Association
Subject
Articles
ISSN
1945-7715
eISSN
1945-7715
DOI
10.1257/mac.2.3.1
Publisher site
See Article on Publisher Site

Abstract

Abstract I describe two amplifications mechanisms that operate during crises and discuss the benefits of policy given each mechanism. The first mechanism involves asset prices and balance sheets. A negative shock to agents' balance sheets causes them to liquidate assets, lowering prices, further deteriorating balance sheets and amplifying the shock. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations increase agents' uncertainty about their investments, causing them to disengage from markets and amplifying the crisis. Liquidity provision by the central bank alleviates the crisis in both mechanisms. Ex ante policies such as liquidity/capital requirements may also be beneficial. (JEL E32, E44, G01, G21, G32 )

Journal

American Economic Journal: MacroeconomicsAmerican Economic Association

Published: Jul 1, 2010

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