Efficiency of Central Bank Policy During the Crisis : Role of Expectations in Reinforcing Hoarding Behavior

Investor sentiment proved to be an important factor during the recent financial and current euro crises. At the same time many existing general equilibrium models do not account for agents' expectations, market volatility, or over-pessimism of investors' forecasts. In this paper we incorporate into the DSGE model a financial sector populated by a continuum of banks with heterogeneous forecasts. We simulate the model with expectational shocks calibrated by the values observed during the financial crisis. Our results suggest that expectational shocks alone could generate a recession of a magnitude comparable to the recent crisis. We then conduct a simple exercise to mimic the credit support policy of a central bank. The results indicate that without influencing agents' expectations, the liquidity provision alone reduces the magnitude of the recession, but neither stops it nor shortens its duration. One reason for low efficiency of the policy in our model is that banks hoard the liquidity provided by a central bank