Interest rate policy and interbank market breakdown

Marc Nückles

Economic Modelling, 2020, vol. 91, issue C, 779-789

Abstract: Using a DSGE-model with interbank market frictions, calibrated to match the frequency of financial crises, I investigate central banks' ability to prevent credit-related recessions by following an interest rate rule which accounts for financial conditions —an approach called ‘leaning against the wind’. The model's key feature is that boom-bust cycles emerge as a result of a savings glut and moral hazard in the banking sector. Although financial conditions predict crises, the policy maker cannot break the boom-bust cycle and reduce the crisis-frequency. When crises become more likely, low inflation forces the central bank to decrease the interest rate despite its intention to do otherwise. Responding to crisis-predictors eventually dilutes the primary objective of stabilizing inflation and leads to higher inflation volatility. The results suggest that central banks should refrain from leaning against the wind.

Keywords: Interbank market; Financial crises; Monetary policy; Leaning against the wind; Taylor rule (search for similar items in EconPapers)
JEL-codes: E32 E44 E52 E58 G01 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:91:y:2020:i:c:p:779-789

DOI: 10.1016/j.econmod.2019.10.035

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