Watering a lemon tree: heterogeneous risk taking and monetary policy transmission

Dong Beom Choi, Thomas Eisenbach and Tanju Yorulmazer

No 724, Staff Reports from Federal Reserve Bank of New York

Abstract: We build a general equilibrium model with financial frictions that impede monetary policy transmission. Agents with heterogeneous productivity can increase investment by levering up, which increases liquidity risk due to maturity transformation. In equilibrium, more productive agents choose higher leverage than less productive agents, which exposes the more productive agents to greater liquidity risk and makes their investment less responsive to interest rate changes. When monetary policy reduces interest rates, aggregate investment quality deteriorates, which blunts the monetary stimulus and decreases asset liquidation values. This, in turn, reduces loan demand, decreasing the interest rate further and generating a negative spiral. Overall, the allocation of credit is distorted and monetary stimulus can become ineffective even with significant interest rate drops.

Keywords: monetary policy transmission; financial frictions; heterogeneous agents; financial intermediation (search for similar items in EconPapers)
JEL-codes: E52 E58 G20 (search for similar items in EconPapers)
Date: 2015-04-01
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: Revised April 2020
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Citations: View citations in EconPapers (1)

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Journal Article: Watering a lemon tree: Heterogeneous risk taking and monetary policy transmission (2021)
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