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

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

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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; financial intermediation wedge; inside money deposits; liquidity creation; long-run non-neutrality; money-financing; reserve management (search for similar items in EconPapers)
JEL-codes: E41 E44 E51 E63 (search for similar items in EconPapers)
Pages: 16 pages
Date: 2023-08-01
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-fdg and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Published in Journal of Financial Stability, 1, August, 2023, 67. ISSN: 1572-3089

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Related works:
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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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119771

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