Paper #853

Title:

Banks, liquidity crises and economic growth

Authors:

Alejandro Gaytan and Romain Rancière

Date:

August 2001 (Revised: May 2003)

Abstract:

How do the liquidity functions of banks affect investment and growth at different stages of economic development? How do financial fragility and the costs of banking crises evolve with the level of wealth of countries? We analyze these issues using an overlapping generations growth model where agents, who experience idiosyncratic liquidity shocks, can invest in a liquid storage technology or in a partially illiquid Cobb Douglas technology. By pooling liquidity risk, banks play a growth enhancing role in reducing inefficient liquidation of long term projects, but they may face liquidity crises associated with severe output losses. We show that middle income economies may find optimal to be exposed to liquidity crises, while poor and rich economies have more incentives to develop a fully covered banking system. Therefore, middle income economies could experience banking crises in the process of their development and, as they get richer, they eventually converge to a financially safe long run steady state. Finally, the model replicates the empirical fact of higher costs of banking crises for middle income economies. –

Keywords:

OLG growth models, liquidity, financial intermediation, financial fragility, banking crises

JEL codes:

E44, G21, O11

Area of Research:

Macroeconomics and International Economics

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