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

Abstract: 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.

Date: 2015-05
Note: paper number DPS 15.09
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Citations: View citations in EconPapers (1)

Published in CES - Discussion paper series,, pages 1-39

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Related works:
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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