Illiquidity and Interest Rate Policy

Douglas W. Diamond and Raghuram G. Rajan

No 15197, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The cheapest way for banks to finance long term illiquid projects is typically to borrow short term from households. But when household needs for funds are high, interest rates will rise sharply, debtors will have to shut down illiquid projects, and in extremis, will face more damaging runs. Authorities may want to push down interest rates to maintain economic activity in the face of such illiquidity, but intervention may not always be feasible, and when feasible, could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off. Authorities may want to commit to a specific policy of interest rate intervention to restore appropriate incentives. For instance, to offset incentives for banks to make more illiquid loans, authorities may have to commit to raising rates when low, to counter the distortions created by lowering them when high. We draw implications for interest rate policy to combat illiquidity.

JEL-codes: E4 E44 E5 E52 E58 G01 G21 G38 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2009-07
Note: CF ME
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