Liquidity monetary policy and financial cycles, Inglese

Liquidity, monetary policy and financial cycles

A close look at how financial intermediaries manage their balance sheets suggests that these institutions raise their leverage during asset price booms and lower it during downturns. The authors of this study argue that the growth rate of aggregate balance sheets is the most fitting measure of liquidity in a market-based financial system. Moreover, the authors show a strong correlation between balance sheet growth and monetary policy.

So, institutions increase their leverage during booms and reduce it during downturns. So financial institutions' leverage is “pro-cyclical”; the expansion and contraction of balance sheets amplifies, rather than counteracts, the credit cycle. In line with the focus on balance sheets management, is presented a new definition of liquidity as the growth rate of financial intermediaries’ balance sheets.

Monetary policy and its effects

When monetary policy is “loose”, financial institutions expand their balance sheets and the supply of liquidity increases. Conversely, when monetary policy is “tight”, institutions shrink their balance sheets, reducing the overall supply of liquidity.

Consequences of pro-cyclical leverage

Pro-cyclical leverage offers a window on the notion of financial system liquidity. Pro-cyclical leverage reverses the normal demand and supply responses to asset price changes.