May 27, 2010 FINANCIAL CRISES AND LIQUIDITY SHOCKS A Bank-Run Perspective

In contrast with the financial multiplier literature, this note explores a case in which the shock triggering a financial crisis stems from the financial sector itself; it is not a shock stemming from the real sector which gets amplified by, say, agency problems. The micro foundations are provided by the bank run literature epitomized by the seminal paper by Diamond and Dybvig (1983). Financial development is thus seen as a mechanism that endows real assets (e.g., land and capital) with liquidity. Likewise, a liquidity crunch associated with a bank run implies a brutal liquidity destruction, and a switch to an equilibrium displaying much lower liquidity. Liquidity creation enhances real asset prices, while a liquidity crunch generates asset price collapse. This bubble-looking episode is not driven by standard fundamentals but is still fully in line with rationality. In this context, devoid of other frictions like price stickiness, the note examines the effect of monetary policy. It shows that preventing price deflation is not enough to offset relative (to output) asset price meltdown, but lower policy interest rates increase relative asset prices and steady-state output. Moreover, in the neighborhood of a first-best capital allocation, an increase in the moneyness of capital may lower the welfare of the representative individual, even if the higher liquidity of capital is sustainable and, hence, not destroyed by future crash. An extension of the basic model supports the conjecture that low policy interest rates may have given incentives to the development of “shadow banking.” * This is a thoroughly revised version of a paper circulated on October 5, 2009. I am grateful to Alejandro Izquierdo, Ivan Khotulev and Enrique Mendoza for useful comments.