Throughout the semester, we have extensively learned about different types of money and how they are woven together by a system of dealers consisting of the central bank, banks, and security dealers to form a hierarchy of money. Our journey so far has focused on the functioning of the hierarch from the perspective of the system of dealers. The goal of this assignment is to take our journey one step further by delving into how different types of liquidity risks arise in the hierarchy, how they are interlinked, and how the central bank can manage them. In answering the following essay questions, try to use your own words to convey the main piece of information and the key line of reasoning. Quoting too heavily or failing to quote properly will result in little or no credit.
1. Definitions. Define and explain three main types of liquidity, namely, the central bank liquidity, funding liquidity, and market liquidity.
2. Liquidity linkages in normal times. Explain how the three types of liquidity are interconnected in normal times.
3. Liquidity linkages in turbulent times. Funding liquidity risk is intrinsic to banking. Explain.
4. Liquidity linkages in turbulent times. Explain the transmission mechanism from funding liquidity risk to market liquidity risk.
5. Liquidity linkages in turbulent times. Explain the feedback mechanism from market liquidity risk back to funding liquidity risk.
6. Liquidity linkages in turbulent times. Explain how the liquidity of the central bank together with its supervision and regulation can stabilize the financial system.
