After the Financial Crisis
Elgar original reference
Edited by Sylvester Eijffinger and Donato Masciandaro
Francesco Giavazzi and Alberto Giovannini1 Introduction This chapter reviews the factors that make a financial system fragile and discusses the interaction between financial fragility and monetary policy. We argue that financial fragility is a deeper phenomenon than that which manifests itself when the price of some financial assets appear to follow a bubble. The fundamental fragility of a financial market does not arise from irrational behavior (although such irrationality seems to be routinely observed in financial markets). The fundamental fragility of a financial system arises from its role in liquidity transformation. We shall illustrate a few examples of liquidity transformation, and the nature of the market fragility associated with it. As it will be apparent from the different examples, liquidity transformation is a central and ever-present function of financial markets. And therefore the ‘fragility’ of financial markets is an unavoidable fact of life. The challenge for policymakers, including central banks, is how to minimize the occurrence of financial crises which arise from a breakdown of liquidity transformation, and how to design their policy taking into account the possibility that such crises might occur. We argue that a crucial variable in the Taylor rule, the tool most central banks use, albeit in quite different forms, to set the level of interest rates, is the real rate of interest the rule targets. Central banks 1 This paper was originally written for the Conference in Honour of Pentti Kouri: Helsinki, 10–11 June, 2010. We thank Ricardo Caballero, Stephen Cecchetti and Fausto Panunzi...