NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Amplification Mechanisms in Liquidity Crises

Arvind Krishnamurthy

NBER Working Paper No. 15040
Issued in June 2009
NBER Program(s):   AP   CF   ME

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.

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