Working Paper: NBER ID: w15425
Authors: Guillermo A. Calvo
Abstract: This note is motivated by trying to understand the macroeconomic implications of assuming that periods of financial bonanza and turmoil are driven by financial innovation and collapse in line with the "bank run" literature of the Diamond-Dybvig (1983) variety. Bypassing a host of important but, for the present purposes, secondary details the note assumes that the initial effects of financial innovation and crash can be summarized by a parameter that determines the "liquidity" or "moneyness" of land or capital. This simplification helps to shed light on some issues that are at the center of the policy debate. In particular, one can show that preventing price deflation is not enough to offset asset meltdown. Furthermore, lower policy interest rates increase asset prices and steady-state output which, however, gets reversed as liquidity is destroyed. An interesting result is that, in the neighborhood of a first-best capital allocation, an increase in the moneyness of capital may lower the welfare of the representative individual, even if the higher liquidity of capital is sustainable and, hence, not destroyed by future crash. Moreover, an extension of the basic model supports the conjecture that low policy interest rates may have given incentives to the development of "shadow banking."
Keywords: financial crises; liquidity shocks; bank runs; financial innovation; shadow banking
JEL Codes: E5; E58; F41; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial innovation (G29) | Increased liquidity (G19) |
| Increased liquidity (G19) | Increased asset prices (G19) |
| Increased liquidity (G19) | Increased steady-state output (E23) |
| Liquidity destruction (G33) | Decreased asset prices (G19) |
| Lower policy interest rates (E43) | Increased asset prices (G19) |
| Lower policy interest rates (E43) | Decreased welfare if liquidity is not sustained (E44) |
| Increase in moneyness of capital (E49) | Lower individual welfare (D69) |