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A model to analyse financial fragility

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  • Goodhart, Charles
  • Sunirand, Pojanart
  • Tsomocos, Dimitrios P.

Abstract

Our purpose in this paper is to produce a tractable model which illuminates problems relating to individual bank behaviour and risk-taking, to possible contagious interrelationships between banks, and to the appropriate design of prudential requirements and incentives to limit ‘excessive’ risk-taking. Our model is rich enough to include heterogenous agents (commercial banks and investors), endogenous default, and multiple commodity, and credit and deposit markets. Yet, it is simple enough to be effectively computable. Financial fragility emerges naturally as an equilibrium phenomenon. In our model a version of the liquidity trap can occur. Moreover, the Modigliani-Miller proposition fails either through frictions in the (nominal) financial system or through incentives, arising from the imposed capital requirements, for differential investment behaviour because of capital requirements. In addition, a non-trivial quantity theory of money is derived, liquidity and default premia co-determine interest rates, and both regulatory and monetary policies have non-neutral effects. The model also indicates how monetary policy may affect financial fragility, thus highlighting the trade-off between financial stability and economic efficiency.

Suggested Citation

  • Goodhart, Charles & Sunirand, Pojanart & Tsomocos, Dimitrios P., 2004. "A model to analyse financial fragility," LSE Research Online Documents on Economics 24703, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:24703
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    References listed on IDEAS

    as
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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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