Bank credit, inflation, and default risks over an infinite horizon

Charles A.E. Goodhart, Dimitrios Tsomocos and Xuan Wang

Journal of Financial Stability, 2023, vol. 67, issue C

Abstract: The financial intermediation wedge of the banking sector used to co-move positively with the federal funds rate, but the post-GFC era saw a disconnect between them. We develop a flexible price dynamic general equilibrium with banks’ liquidity creation to offer an explanation. In a corridor system, the financial wedge and policy rate are shown to co-move, and the pass-through of monetary policy onto both inflation and output obtains. However, the post-GFC floor system obviates the need for the financial wedge to cover the cost of obtaining reserves, so the wedge and the policy rate indeed disconnect in equilibrium; furthermore, we show that the disconnect obstructs monetary expansions from generating inflation. In this environment, tightening bank capital requirement leads to disinflationary pressure. Money-financed fiscal expansions that subsidise non-bank sectors’ borrowing costs improve output and reduce default risks but increase inflation. The model uses banks’ liquidity creation via credit extension to provide a rationale for both the pre-pandemic disinflation and the post-pandemic inflation. The results hold both on the dynamic paths and in the steady state, and the role of money enlarges the Taylor rule determinacy region.

Keywords: Corporate default; Liquidity creation; Inside money deposits; Reserve management; Long-run non-neutrality; Money-financing; Financial intermediation wedge (search for similar items in EconPapers)
JEL-codes: E41 E44 E51 E63 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Related works:
Working Paper: Bank Credit, Inflation, and Default Risks over an Infinite Horizon (2023)
Working Paper: Bank credit, inflation, and default risks over an infinite horizon (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:67:y:2023:i:c:s1572308923000311

DOI: 10.1016/j.jfs.2023.101131

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