The Prime Rate-Deposit Rate Spread and Macroeconomic Shocks

This paper examines the response of the prime rate–deposit rate spread to shocks in real output growth, inflation, and the stance of monetary policy. A simple model of the lending and deposit markets is introduced that provides insight as to how these macroeconomic factors might affect the spread. The paper employs the recently developed technique of generalized impulse response analysis proposed. This method does not impose a priori restrictions as to the relative importance each of the variables in the underlying vector autoregression may play in the transmission process. Thus, the results provide robust evidence as to the relationship between the prime rate-deposit rate spread and these macroeconomic factors. Specifically, the model suggests and the empirical results confirm that shocks to inflation widen the spread while unexpected changes in the federal funds rate and real output growth lead to a narrower spread.