CXO

Financial Imbalances And Financial Fragility

Date Added: Apr 2011
Format: PDF

This paper develops a general equilibrium model to analyze the link between financial imbalances and financial crises. The model features an interbank market subject to frictions and where two equilibria may (co-)exist. The normal times equilibrium is characterized by a deep market with highly leveraged banks. The crisis time's equilibrium is characterized by bank deleveraging, a market run, and a liquidity trap. Crises occur when there is too much liquidity (savings) in the economy with respect to the number of (safe) investment opportunities. In effect, the economy is shown to have a limited liquidity absorption capacity, which depends - inter alia - on the productivity of the real sector, the ultimate borrower.