Liquidity, Duration, and the “Financial” Transmission Mechanism

Abstract

This article analyzes the impact of liquidity on financial markets and on the real economy through a “new” risk channel. The 2007/2008 crisis (and the subsequent market rebound) shows the importance of private sector credit provision and suggests that the influence of central banks operating through the monetary base outweighs the effect of the traditional policy lever, the overnight interest rate. The authors use a VAR model to show the importance of capital market variables, such as risk aversion and risk premia, to credit supply and to this transmission process. They try to establish the exogeneity of U.S. central bank money, and the important adjustment role played by duration. The study suggests that credit provision is highly pro-cyclical because of its connection to risk. They infer that monetary policy can no longer be set by the single dimension of the Federal Funds rate but needs to broaden out to monitor the balance sheets of credit providers and to understand its impact on risk variables.