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)
"Amplification Mechanisms in Liquidity Crises."
American Economic Journal: Macroeconomics,
Business Fluctuations; Cycles
Financial Markets and the Macroeconomy
Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure