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“Interest Rate Trap”, or Why Does the Central Bank Keep the Policy Rate Too Low for Too Long?

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  • Jin Cao
  • Gerhard Illing

Abstract

In this paper, we provide a framework for modeling one risk-taking channel of monetary policy, the mechanism whereby financial intermediaries' incentives for liquidity transformation are affected by the central bank's reaction to a financial crisis. The anticipation of the central bank's reaction to liquidity stress gives banks incentives to invest in excessive liquidity transformation, triggering an “interest rate trap” – the economy will remain stuck in a long-lasting period of suboptimal, low interest rate equilibrium. We demonstrate that interest rate policy as a financial stabilizer is dynamically inconsistent, and the constrained efficient outcome can be implemented by imposing ex ante liquidity requirements.

Suggested Citation

  • Jin Cao & Gerhard Illing, 2015. "“Interest Rate Trap”, or Why Does the Central Bank Keep the Policy Rate Too Low for Too Long?," Scandinavian Journal of Economics, Wiley Blackwell, vol. 117(4), pages 1256-1280, October.
    • Handle: RePEc:bla:scandj:v:117:y:2015:i:4:p:1256-1280
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    File URL: http://hdl.handle.net/10.1111/sjoe.12118
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    Citations

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    Cited by:

    1. Gilbert COLLETAZ & Grégory LEVIEUGE & Alexandra POPESCU, 2016. "Monetary Policy and Long-Run Risk-Taking," LEO Working Papers / DR LEO 2409, Orleans Economics Laboratory / Laboratoire d'Economie d'Orleans (LEO), University of Orleans.
    2. Colletaz, Gilbert & Levieuge, Grégory & Popescu, Alexandra, 2018. "Monetary policy and long-run systemic risk-taking," Journal of Economic Dynamics and Control, Elsevier, vol. 86(C), pages 165-184.
    3. Chen, Minghua & Wu, Ji & Jeon, Bang Nam & Wang, Rui, 2017. "Monetary policy and bank risk-taking: Evidence from emerging economies," Emerging Markets Review, Elsevier, vol. 31(C), pages 116-140.
    4. Cao, Jin & Chollete, Lorán, 2017. "Monetary policy and financial stability in the long run: A simple game-theoretic approach," Journal of Financial Stability, Elsevier, vol. 28(C), pages 125-142.
    5. Patrick Matussek, 2017. "Low interest rates and life insurance with equity insurance fund on German market (Niskie stopy procentowe a ubezpieczenia na zycie z ubezpieczeniowym funduszem kapitalowym na rynku niemieckim)," Research Reports, University of Warsaw, Faculty of Management, vol. 2(24), pages 142-149.

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