Dual Liquidity Crises - A Financial Accounts Framework

Abstract

This paper analyzes dual liquidity crises, i.e. funding crises which encompass the private and the public sector, and the shock absorbing capacity of central banks within a closed system of financial accounts. We find that a central bank that operates under a flexible exchange rate is most effective in containing a dual liquidity crisis. A central bank of a euro area type monetary union has a similar capacity as long as the integrity of the union is beyond doubt. By contrast, within any fixed exchange rate system the availability of inter‐central bank credit determines the elasticity of a central bank in providing liquidity. Finally, domestic constraints, i.e. collateral rules, risk taking ability or legal prohibitions, can limit the elasticity of the central bank's response to liquidity shocks.