TY  - JOUR
AU  - Diamond,Douglas W.
AU  - Rajan,Raghuram G.
TI  - Illiquidity and Interest Rate Policy
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 15197
PY  - 2009
Y2  - July 2009
UR  - http://www.nber.org/papers/w15197
L1  - http://www.nber.org/papers/w15197.pdf
N1  - Author contact info:
Douglas W. Diamond
Booth School of Business
University of Chicago
5807 S Woodlawn Avenue
Chicago, IL 60637
Tel: 773/702-7283
E-Mail: douglas.diamond@chicagobooth.edu

Raghuram Rajan
Booth School of Business
University of Chicago
5807 South Woodlawn Avenue
Chicago, IL 60637
Tel: 773/702-4437
Fax: 773/702-0458
E-Mail: raghuram.rajan@ChicagoBooth.edu
AB  - The cheapest way for banks to finance long term illiquid projects is typically to borrow short term from households. But when household needs for funds are high, interest rates will rise sharply, debtors will have to shut down illiquid projects, and in extremis, will face more damaging runs. Authorities may want to push down interest rates to maintain economic activity in the face of such illiquidity, but intervention may not always be feasible, and when feasible, could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off. Authorities may want to commit to a specific policy of interest rate intervention to restore appropriate incentives. For instance, to offset incentives for banks to make more illiquid loans, authorities may have to commit to raising rates when low, to counter the distortions created by lowering them when high. We draw implications for interest rate policy to combat illiquidity.
ER  -