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An independent central bank can manage its balance sheet and its capital so as to commit itself to a depreciation of its currency and an exchange-rate peg. This way, the central bank can implement the optimal escape from a liquidity trap, which involves a commitment to higher future inflation. This commitment mechanism works even though, realistically, the central bank cannot commit itself to a particular future money supply. It supports the feasibility of Svensson's Foolproof Way to escape from a liquidity trap.
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Banks can fail either because they are insolvent or because an aggregate shortage of liquidity can render them insolvent. We show that bank failures can themselves cause liquidity shortages. The failure of some banks can then lead to a cascade of failures and a possible total meltdown of the system. Contagion here is not caused by contractual or informational links between banks but because bank failure could lead to a contraction in the common pool of liquidity. There is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact, and can each cause the other. It is therefore hard to determine the root cause of a crisis from observable factors. The practical difficulty of determining the most appropriate intervention, as well as the costs of the wrong kind of intervention (such as infusing capital when the need is for liquidity) have to be traded off against the costs of a meltdown, which can be substantial. We propose a robust sequence of intervention.
Bank failures. --- Bank liquidity. --- Industrial productivity.
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Bank liquidity. --- Risk management. --- Insurance --- Management --- Liquidity (Economics) --- Private finance
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Bank investments --- Bank liquidity --- Administrative regulation drafting --- Government policy
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Bank liquidity --- Bank management --- Risk management --- Asset-liability management
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Bank investments --- Bank liquidity --- Banking law --- Government policy
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