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Interest rate rules under financial dominance

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  • Lewis, Vivien
  • Roth, Markus

Abstract

We study the equilibrium properties of a business cycle model with financial frictions and price adjustment costs. Capital-constrained entrepreneurs finance risky projects by borrowing from banks. Banks, in turn, make loans using equity and deposits. Because financial contracts are not contingent on aggregate risk, bank balance sheets are hit when entrepreneurial defaults are higher than expected. Macroprudential policy imposes a positive response of the bank capital ratio to lending. Our main result is that the Taylor Principle is violated when this response is too weak. Then macroprudential policy is ineffective in stabilizing debt and monetary policy is subject to 'financial dominance'. A too aggressive response of the interest rate to inflation can lead to debt disinflation dynamics that destabilize the financial sector.

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  • Lewis, Vivien & Roth, Markus, 2018. "Interest rate rules under financial dominance," Discussion Papers 29/2018, Deutsche Bundesbank.
    • Handle: RePEc:zbw:bubdps:292018
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    Cited by:

    1. Grégory Levieuge, 2018. "La politique monétaire doit-elle être utilisée à des fins de stabilité financière ?," Revue française d'économie, Presses de Sciences-Po, vol. 0(3), pages 63-104.
    2. Tom D. Holden, 2024. "Robust Real Rate Rules," Econometrica, Econometric Society, vol. 92(5), pages 1521-1551, September.
    3. Vivien Lewis & Stefania Villa, 2016. "The Interdependence of Monetary and Macroprudential Policy under the Zero Lower Bound," Working Paper Research 310, National Bank of Belgium.
    4. Chrysanthopoulou Xakousti & Mylonidis Nikolaos & Sidiropoulos Moise, 2024. "Regulatory capital requirements, inflation targeting, and equilibrium determinacy," Working Papers of BETA 2024-05, Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg.
    5. Chang Cheng-Wei & Lai Ching-Chong, 2017. "Macroeconomic (in)stability and endogenous market structure with productive government expenditure," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 21(2), pages 1-16, April.

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    More about this item

    Keywords

    bank capital; financial dominance; interest rate rule; macroprudential policy; Taylor Principle;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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