Bank Credit, Inflation, and Default Risks over an Infinite Horizon

Charles Goodhart, Dimitrios Tsomocos and Xuan Wang

No 18042, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 of 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.

JEL-codes: E41 E44 E51 E63 (search for similar items in EconPapers)
Date: 2023-03
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Journal Article: 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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