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Traditionally, aggregate liquidity shocks are modeled as exogenous events. This paper analyzes the adequate policy response to endogenous exposure to systemic liquidity risk. We analyze the feedback between lender-of-last-resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante is a crucial requirement for sensible lender-of-last-resort policy. In addition, we analyze the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that both policies are strictly inferior to imposing minimum liquidity standards ex ante combined with lender-of-last-resort policy.
This instructor's manual complements the textbook Money: Theory and Practice which provides an introduction to modern monetary economics for advanced undergraduates, highlighting the lessons learned from the recent financial crisis.
This textbook provides an introduction to modern monetary economics for advanced undergraduates, highlighting the lessons learned from the recent financial crisis. Part I examines the long-run perspective, addressing classical monetary policy issues such as determination of the price level and interaction between monetary and fiscal policy.
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