Interbank Trade: Why It’s Good and How to Get It

Garth Baughman and Francesca Carapella

Journal of Political Economy Macroeconomics, 2025, vol. 3, issue 4, 674 - 744

Abstract: We provide a theory for the collapse in bank-to-bank lending since the introduction of a floor system for monetary policy. Our theory incorporates a key feature of the federal funds market: unsecured credit. When the punishment for failing to repay loans is exclusion from interbank markets, when interest rates are too low, borrowing banks have no incentive to repay their loans, the endogenous borrowing limit is zero, and bank-to-bank lending collapses, despite banks still needing to borrow. We propose a framework to implement monetary policy that restores an active interbank market, and we provide conditions for it to be welfare improving.

Date: 2025
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