Dynamic Consequences of Monetary Policy for Financial Stability

William Chen and Gregory Phelan

No 2018-06, Department of Economics Working Papers from Department of Economics, Williams College

Abstract: We theoretically investigate the state-dependent effects of monetary policy on macroeconomic instability. In the model, banks borrow using deposits and allocate resources to productive projects. Because banks do not actively issue equity, aggregate outcomes depend on the level of equity in the financial sector. Carefully targeted monetary policy can improve stability by increasing the rate of bank equity growth, and improve allocations by encouraging leverage when intermediation is needed. A fed put is generally stabilizing, but the marginal impact of a rate cut depends on the state of the economy. The effectiveness of monetary policy depends on the extent to which rate cuts pass through to bank returns. When banks are relatively well-capitalized, rate cuts primarily decrease banks' returns. In terms of welfare, the costs of "leaning against the wind" generally outweigh the benefits, but a fed put can improve outcomes if the costs of deviating from the inflation target are sufficiently small.

Keywords: Monetary policy; Leaning against the wind; Financial stability; Macroeconomic instability; Banks; Liquidity (search for similar items in EconPapers)
JEL-codes: E44 E52 E58 G01 G12 G20 G21 (search for similar items in EconPapers)
Pages: 58 pages
Date: 2018-10
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
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