Working Paper: NBER ID: w15040
Authors: Arvind Krishnamurthy
Abstract: I describe two amplifications mechanisms that operate during liquidity crises and discuss the scope for central bank policies during crises as well as preventive policies in advance of crises. The first mechanism works through asset prices and balance sheets. A negative shock to the balance sheets of asset-holders causes them to liquidate assets, lowering prices, further deteriorating balance sheets, culminating in a crisis. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations lead agents to become uncertain about their investments causing them to disengage from markets and increase their demand for liquidity. This behavior leads to a loss of liquidity and a crisis.
Keywords: No keywords provided
JEL Codes: G01; G18; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative asset price shock (G19) | tighter balance sheet constraints (G32) |
| tighter balance sheet constraints (G32) | asset liquidations (G33) |
| asset liquidations (G33) | further price declines (E30) |
| negative asset price shock (G19) | further price declines (E30) |
| unusual shocks to financial innovations (G19) | increased investor uncertainty (D89) |
| increased investor uncertainty (D89) | disengagement from markets (F69) |
| disengagement from markets (F69) | increased liquidity demand (E41) |
| increased liquidity demand (E41) | liquidity crisis (G01) |
| knightian uncertainty (D80) | disengagement from markets (F69) |
| knightian uncertainty (D80) | liquidity crisis (G01) |