WP Global Economy 2014.01.31
We develop a simple macroeconomic model that captures key features of a liquidity crisis. During a crisis, the supply of short-term loans vanishes, the interest rate rises sharply, and the level of economic activity declines. A crisis may be caused either by self-ful lling beliefs or by fundamental shocks. It occurs as a result of market failure due to debt overhang in short-term loans. The government's commitment to deposit guarantee reduces the likelihood of self-ful lling crisis but increases that of fundamental crisis.