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American Economic Journal: Macroeconomics: Vol. 2 No. 3 (July 2010)

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Amplification Mechanisms in Liquidity Crises

Article Citation

Krishnamurthy, Arvind. 2010. "Amplification Mechanisms in Liquidity Crises." American Economic Journal: Macroeconomics, 2(3): 1-30.

DOI: 10.1257/mac.2.3.1

Abstract

I describe two amplifications mechanisms that operate during crises and discuss the benefits of policy given each mechanism. The first mechanism involves asset prices and balance sheets. A negative shock to agents' balance sheets causes them to liquidate assets, lowering prices, further deteriorating balance sheets and amplifying the shock. The second mechanism involves investors' Knightian uncertainty. Unusual shocks to untested financial innovations increase agents' uncertainty about their investments, causing them to disengage from markets and amplifying the crisis. Liquidity provision by the central bank alleviates the crisis in both mechanisms. Ex ante policies such as liquidity/capital requirements may also be beneficial. (JEL E32, E44, G01, G21, G32)

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Authors

Krishnamurthy, Arvind (Northwestern U)

JEL Classifications

E32: Business Fluctuations; Cycles
E44: Financial Markets and the Macroeconomy
G01: Financial Crises
G21: Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G32: Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure

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American Economic Journal: Macroeconomics


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