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Financial Shocks, Loan Loss Provisions and Macroeconomic Stability

William Tayler () and Roy Zilberman

No 124138133, Working Papers from Lancaster University Management School, Economics Department

Abstract: This paper studies the interactions between loan loss provisions, business cycles and monetary policy in a New Keynesian model featuring a credit cost channel and endogenous credit default risk. We show that an incurred-loss specific provisioning system induces financial accelerator mechanisms, and generates financial, price and macroeconomic instability. Dynamic provisioning regimes, covering for expected losses over the whole business cycle, significantly improve welfare, and furthermore moderate the (otherwise optimal) anti-inflationary stance in the monetary policy rule. Optimal policy in response to financial shocks calls for a combination of macroprudential dynamic provisioning and conventional monetary policy rules, which exclude financial stability targets.

Keywords: Basel III - Macroprudential Policy; Dynamic Provisions; Borrowing Cost Channel; Monetary Policy; Welfare (search for similar items in EconPapers)
JEL-codes: E32 E44 E52 E58 G28 (search for similar items in EconPapers)
Date: 2014
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