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A Model of Credit, Money, Interest, and Prices

Saki Bigio and Yuliy Sannikov

No 28540, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper integrates a realistic implementation of monetary policy through the banking system into an incomplete-markets economy with wage rigidity. Monetary policy sets policy rates and alters the supply of reserves. These tools grant independent control over credit spreads and an interest target. Through these tools, monetary policy affects the evolution of real interests rates, credit, output, and the wealth distribution—both in the long and in the short run. We decompose the effects through a combination of the interest and credit channels that depend on the size of the central bank’s balance sheet. Monetary policy reaches an expansionary limit when it enters a liquidity trap. The model highlights a trade-off between worse microeconomic insurance (insurance across agents) and greater macroeconomic insurance (insurance across states). The model prescribes that monetary policy should operate with a small balance sheet which tightens credit during booms, and should expand its balance sheet and lower policy rates during busts.

JEL-codes: E31 E32 E41 E42 (search for similar items in EconPapers)
Date: 2021-03
New Economics Papers: this item is included in nep-cba, nep-cwa, nep-ias, nep-mac and nep-mon
Note: EFG ME
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