Optimal Liquidity Provision and Interest Rate Rules: A Tale of Two Frictions

Paul Levine (), Maryam Mirfatah, Joseph Pearlman and Stylianos Tsiaras
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Maryam Mirfatah: King’s College London
Stylianos Tsiaras: Ecole Polytechnique Federale de Lausanne

No 1323, School of Economics Discussion Papers from School of Economics, University of Surrey

Abstract: We study central bank liquidity provisions to the banking sector in a DSGE model estimated for the Euro Area with financial frictions on the supply and demand side of credit. We show that liquidity provisions, as in the ECB’s recent Long Term Refinancing Operations, can be welfare-enhancing or welfare-reducing when both these financial frictions exist. They relax the banks’ leverage constraint and induce banks to provide more credit. This reduces the credit spread facing firms and increases investment, but this comes at the cost of implementing the liquidity policy. We compute a welfare optimized liquidity rule for the central bank responding to output, inflation and the interest rate spread that can increase welfare in comparison with the case of no liquidity provision. Crucially, this result is conditional on a high level of central bank monitoring of the its loanable funds to banks.

JEL-codes: C11 E44 E52 E58 E61 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2023-11
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-eec, nep-fdg, nep-ifn, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:sur:surrec:1323

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