A model to analyse financial fragility

Charles Goodhart, Pojanart Sunirand and Dimitrios Tsomocos

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: Our purpose in this paper is to produce a tractable model which illuminates problems relating to individual bank behaviour and risk-taking, to possible contagious interrelationships between banks, and to the appropriate design of prudential requirements and incentives to limit ‘excessive’ risk-taking. Our model is rich enough to include heterogenous agents (commercial banks and investors), endogenous default, and multiple commodity, and credit and deposit markets. Yet, it is simple enough to be effectively computable. Financial fragility emerges naturally as an equilibrium phenomenon. In our model a version of the liquidity trap can occur. Moreover, the Modigliani-Miller proposition fails either through frictions in the (nominal) financial system or through incentives, arising from the imposed capital requirements, for differential investment behaviour because of capital requirements. In addition, a non-trivial quantity theory of money is derived, liquidity and default premia co-determine interest rates, and both regulatory and monetary policies have non-neutral effects. The model also indicates how monetary policy may affect financial fragility, thus highlighting the trade-off between financial stability and economic efficiency.

JEL-codes: D52 E40 E50 G10 G20 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2004-04
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (63)

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http://eprints.lse.ac.uk/24703/ Open access version. (application/pdf)

Related works:
Journal Article: A model to analyse financial fragility (2006)
Working Paper: A Model to Analyse Financial Fragility (2003)
Working Paper: A Model to Analyse Financial Fragility (2003)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:24703

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