Interest rate rules under financial dominance
Vivien Lewis () and
Markus Roth ()
No 497594, Working Papers of Department of Economics, Leuven from KU Leuven, Faculty of Economics and Business (FEB), Department of Economics, Leuven
In our dynamic stochastic general equilibrium model, capital-constrained entrepreneurs finance risky projects by borrowing from banks. Banks make loans using equity and deposits. Because financial contracts are non-state-contingent, bank balance sheets are exposed to entrepreneurial defaults. Macroprudential policy imposes a positive response of the bank capital ratio to lending. Our main result is that the Taylor Principle is violated when this response is too weak. Then macro-prudential policy is ineffective in stabilising debt and monetary policy is subject to ‘financial dominance’. Under a constant bank capital requirement, a strong reaction of the interest rate to inflation destabilises the financial sector.
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Published in CES - Discussion paper series, DPS15.09 , pages 1-39
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Journal Article: Interest rate rules under financial dominance (2018)
Working Paper: Interest rate rules under financial dominance (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:ete:ceswps:497594
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