Winter is possibly not coming: mitigating financial instability in an agent-based model with interbank market
Abstract
We develop a macroeconomic agent-based model to study how financial instability can emerge from the co-evolution of
interbank and credit markets and the policy responses to mitigate its impact on the real economy. The model is populated
by heterogenous firms, consumers, and banks that locally interact in dfferent markets. In particular, banks provide credit to
firms according to a Basel II or III macro-prudential frameworks and manage their liquidity in the interbank market. The
Central Bank performs monetary policy according to dfferent types of Taylor rules. We find that the model endogenously
generates market freezes in the interbank market which interact with the financial accelerator possibly leading to firm
bankruptcies, banking crises and the emergence of deep downturns. This requires the timely intervention of the Central
Bank as a liquidity lender of last resort. Moreover, we find that the joint adoption of a three mandate Taylor rule tackling
credit growth and the Basel III macro-prudential frame-work is the best policy mix to stabilize financial and real economic
dynamics. However, as the Liquidity Coverage Ratio spurs financial instability by increasing the pro-cyclicality of banks’
liquid reserves, a new counter-cyclical liquidity buffer should be added to Basel III to improve its performance further.
Finally, we find that the Central Bank can also dampen financial in- stability by employing a new unconventional monetarypolicy tool involving active management of the interest-rate corridor in the interbank market.
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