Interbank Market Liquidity and Central Bank Intervention

Franklin Allen, Elena Carletti and Douglas Gale ()

No ECO2009/09, Economics Working Papers from European University Institute

Abstract: We develop a simple model of the interbank market where banks trade a long term, safe asset. We show that when there is a lack of opportunities for banks to hedge aggregate and idiosyncratic liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. The model shows also that market freezes, where banks stop trading with each other, can be a feature of the constrained efficient allocation if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand.

Keywords: interbank market; liquidity; central bank intervention; open market operations (search for similar items in EconPapers)
JEL-codes: G01 G18 G21 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mon and nep-mst
Date: 2009
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Persistent link: http://EconPapers.repec.org/RePEc:eui:euiwps:eco2009/09

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