Monetary policy operating procedures, lending frictions, and employment

David Florián, Chris Limnios and Carl Walsh
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Chris Limnios: Providence College

No 118, Working Papers from Peruvian Economic Association

Abstract: This paper studies a channel system for implementing monetary policy when bank lending is subject to frictions. These frictions affect the spread between the interbank rate and the loan rate. We show how the width of the channel, the nature of random payment flows in the interbank market and the presence of frictions in the loan market affect the propagation of financial shocks that originate either in the interbank market or in the loan market. We study the transmission mechanism of two different financial shocks: 1) An increase in the volatility of the payment shock that banks face once the interbank market has closed and 2) An exogenous termination of loan contracts that directly affects the probability of continuation of credit relationships. Both financial shocks are propagated through the interaction of the marginal value of having excess reserves as collateral relative to other bank assets, the real marginal cost of labor for all active firms and the reservation productivity that selects the mass of producing firms. Our results suggest that financial shocks produce a reallocation of bank assets towards excess reserves as well as intensive and extensive margin effects over employment. The aggregation of those effects produce deep and prolonged recessions that are associated to fluctuations in the endogenous component of total factor productivity that appears as an additional input in the aggregate production function of the economy. We show that this wedge depends on aggregate credit conditions and on the mass of producing firms.

Keywords: Monetary policy implementation; channel system; central bank; credit frictions (search for similar items in EconPapers)
JEL-codes: E4 G21 (search for similar items in EconPapers)
Date: 2018-02
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac and nep-mon
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Working Paper: Monetary policy operating procedures, lending frictions, and employment (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:apc:wpaper:118

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