Current Issues in Economics and Finance

Liquidity, Monetary Policy, and Financial Cycles

January/February 2008 Volume 14, Number 1
JEL classification: E50, G00, G21

Authors: Tobias Adrian and Hyun Song Shin

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—pro-cyclical actions that tend to exaggerate the fluctuations of the financial cycle. The authors of this study argue that the growth rate of aggregate balance sheets may be the most fitting measure of liquidity in a market-based financial system. Moreover, the authors show a strong correlation between balance sheet growth and the easing and tightening of monetary policy.

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