The Transmission of Liquidity Shocks to the Real Economy

Abstract

This paper uses the 2007-2009 financial crisis as a negative liquidity shock on banks to analyze their lending behavior and study the differences between US and euro-area banks. When faced with a negative liquidity shock, US banks transmitted liquidity shocks to the real economy by reducing the amount of their loans whereas euro-area banks did not show any decline in their lending. The main difference between US and euro-area banks is the ability of finding alternative financing. Euro-area banks were able to issue short-term debt whereas US banks seemed unable to do so. Financing frictions prevented US banks from finding alternative financing which led to a decline in their loan supply. This difference in their access to alternative financing sources could be explained by the different monetary policy responses. Overall, this paper concludes that differences in the monetary policy responses of the Federal Reserve in the US and the ECB in the euro area has led to differences in the transmission of liquidity shocks to the real economy.