Interest rate rules under financial dominance
Vivien Lewis () and
Markus Roth ()
Journal of Economic Dynamics and Control, 2018, vol. 95, issue C, 70-88
We study the equilibrium properties of a business cycle model with financial frictions and price adjustment costs. Capital-constrained entrepreneurs finance risky projects by borrowing from banks. Banks, in turn, make loans using equity and deposits. Because financial contracts are not contingent on aggregate risk, bank balance sheets are hit when entrepreneurial defaults are higher than expected. Macroprudential policy imposes a positive response of the bank capital ratio to lending. Our main result is that the Taylor Principle is violated when this response is too weak. Then macroprudential policy is ineffective in stabilizing debt and monetary policy is subject to ‘financial dominance’. A too aggressive response of the interest rate to inflation can lead to debt disinflation dynamics that destabilize the financial sector.
Keywords: Bank capital; Financial dominance; Interest rate rule; Macroprudential policy; Taylor Principle (search for similar items in EconPapers)
JEL-codes: E32 E44 E52 E58 E61 (search for similar items in EconPapers)
References: View references in EconPapers View complete reference list from CitEc
Citations: Track citations by RSS feed
Downloads: (external link)
Full text for ScienceDirect subscribers only
Working Paper: Interest rate rules under financial dominance (2018)
Working Paper: Interest rate rules under financial dominance (2015)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:95:y:2018:i:c:p:70-88
Access Statistics for this article
Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok
More articles in Journal of Economic Dynamics and Control from Elsevier
Bibliographic data for series maintained by Dana Niculescu ().