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Banks are generally assumed to be able to collect deposits from households and to distribute them without delay to firms in the form of loans.
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Paradoxically, this was also the general assumption that many market participants had before the start of the turmoil, namely that financial risks were so well spread throughout the economy that financial contagion within the industry would be minimal.Īnother failing of the existing macro models is that financial frictions affect firms (or households) and limit their ability to raise external finance, but not banks’ fund-raising activity. Current models are thus not able to capture situations in which the financial distress of a subset of firms (or households) may lead to bank failures as a result of an inability to repay deposits or other types of bank debt instruments. However, it is generally assumed that intermediaries can “diversify away” the risk by lending to an arbitrarily large number of economic agents. Risk arises in firms’ production processes (or in households’ ability to earn income) and affects the ability of firms (or households) to repay their debt. One main shortcoming of the macro models currently available for the analysis of financial stability is that intermediaries are typically assumed not to face risks. Only recently a branch of the literature has started integrating the banking system in DSGE models.
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The reason lies in the steep trade-off faced by modellers between capturing an environment of sophisticated and constantly evolving financial products and the complexity of embedding the financial structure in a general equilibrium framework. Unfortunately, the macro literature typically uses general equilibrium models that feature highly stylised financial sectors. Third, a description of agents’ incentives towards, and capability of, respecting, or defaulting on, their financial obligations in the face of different possible shocks. Second, a set of non-zero (gross and net) financing positions across the main sectors of the economy, most of which are based on nominal debt I will elaborate on some of these today.įinally I will draw some general conclusions on how central banks should behave in the midst of turmoil, such as the episode we are currently experiencing.įirst, forward-looking economic agents who think in an intertemporal manner On this basis it is not possible for policy-makers to formulate precise policy rules, rather only general considerations and warnings as guidance for their actions. Indeed, there is little analytical background that can give definite guidance for assessing the relationship between price stability and financial stability, and the impact that monetary policy can have on financial flows and stocks. What I would like to explain first is that central bankers get little help from the economic and financial literature to guide their actions. While I will not dare to answer the first question, I will endeavour to address the second one by focusing primarily on the conduct of monetary policy, which is the main task of central banks. People are starting to ask – and rightly so – how long it will last and what policy-makers are doing about it. It’s now over 7 months since the start of the financial turmoil. It is an honour and a pleasure for me to speak at this event today.