“Interest Rate Trap”, or Why Does the Central Bank Keep the Policy Rate Too Low for Too Long?

Jin Cao () and Gerhard Illing

Scandinavian Journal of Economics, 2015, vol. 117, issue 4, 1256-1280

Abstract: In this paper, we provide a framework for modeling one risk-taking channel of monetary policy, the mechanism whereby financial intermediaries' incentives for liquidity transformation are affected by the central bank's reaction to a financial crisis. The anticipation of the central bank's reaction to liquidity stress gives banks incentives to invest in excessive liquidity transformation, triggering an “interest rate trap” – the economy will remain stuck in a long-lasting period of suboptimal, low interest rate equilibrium. We demonstrate that interest rate policy as a financial stabilizer is dynamically inconsistent, and the constrained efficient outcome can be implemented by imposing ex ante liquidity requirements.

Date: 2015
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