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Financial Dampening

Mu-Jeung Yang and Johannes Wieland ()
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Mu-Jeung Yang: University of Washington, Seattle

No 1022, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: We propose a novel mechanism, 'financial dampening,' whereby financial sector deleveraging attenuates the effectiveness of monetary policy. In our model of financial intermediation, where banks have leverage targets and asymmetric portfolio adjustment costs, deleveraging banks will have a lower pass-through from reductions in policy rates to credit supply. We find consistent evidence for financial dampening in micro-data on U.S. regulated financial intermediaries. We instrument deleveraging at local banks using average deleveraging at spatially-separate banks of the same bank holding company to isolate local deleveraging independent of local demand conditions. We find that in response to a 1% monetary policy shock, a bank at the 25th percentile of the deleveraging distribution increases its loan growth by 3.70% more than a bank at the 75th percentile according to our baseline specification. Thus, our mechanism provides a rationale for why recoveries from financial crisis may be slow.

Date: 2015
New Economics Papers: this item is included in nep-ban and nep-mon
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