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The macroeconomic effects of liquidity supply during financial crises

Author

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  • Porcellacchia, Davide
  • Sheedy, Kevin D.

Abstract

Negative economic shocks can cause waves of investor pessimism about the resilience of banks, which, in turn, generate additional adverse macroeconomic effects. This is commonly cited as an explanation for the economic havoc wrought by the global financial crisis of 2007-08. We introduce the notion of pessimism in a real business cycle model, which is a standard framework for business cycle analysis. The possibility of waves of pessimism generates countercyclical demand from banks for liquid assets (e.g., bank reserves). With the model, we study the macroeconomic effects of the government supplying liquid assets and find that a policy of accommodating banks’ demand is effective in stabilising the economy. Finally, we support this finding with empirical evidence. JEL Classification: E40, E41, E44, E50, E51, G01, G21

Suggested Citation

  • Porcellacchia, Davide & Sheedy, Kevin D., 2024. "The macroeconomic effects of liquidity supply during financial crises," Research Bulletin, European Central Bank, vol. 125.
    • Handle: RePEc:ecb:ecbrbu:2024:0125:
    Note: 3169100
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    References listed on IDEAS

    as
    1. Itamar Drechsler & Alexi Savov & Philipp Schnabl, 2018. "A Model of Monetary Policy and Risk Premia," Journal of Finance, American Finance Association, vol. 73(1), pages 317-373, February.
    2. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    3. Itay Goldstein & Ady Pauzner, 2005. "Demand–Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, vol. 60(3), pages 1293-1327, June.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    bank lending channel; Bank runs; liquidity;
    All these keywords.

    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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