Amplification Mechanisms in Liquidity Crises
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.
I thank Tobias Adrian, Olivier Blanchard, Markus Brunnermeier, Ricardo Caballero, Andrea Eisfeldt, Zhiguo He, Charles Kahn, the referee, and participants at the WEL-MIT conference and the Chicago Fed's Bank Structure Conference for their comments. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.