Monetary Policy Rules, Adverse Selection and Long-Run Financial Risk
Hans J. Blommestein
Organization for Economic Co-Operation and Development (OECD)
Sylvester C. W. Eijffinger
Tilburg University (CentER) - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)
Tilburg University - European Banking Center, CentER
November 23, 2011
European Banking Center Discussion Paper No. 2011-032
CentER Discussion Paper Series No. 2011-121
This paper constructs a macro-finance model with two types of borrowers: entrepreneurs who engage in productive activities and gamblers who play in lotteries. It links a central bank's interest rate policy to expected cash flows of both types of borrowers. Via this link we study how the interactions between various shocks and different monetary policy rules affect the quality of the borrower pool faced by financial intermediaries. We find that if the economy is hit by an expansionary monetary policy shock, in the long run the proportion of entrepreneurs in the borrower pool will be persistently lower than the steady state level. This worsening of the borrower pool is more serious if the central bank does not react to output fluctuations. By contrast, not reacting to output fluctuations in case of a negative productivity shock avoids a persistent worsening of the borrower pool in the long run.
Number of Pages in PDF File: 58
Keywords: Monetary Policy, Adverse Selection, Financial Crisis
JEL Classification: E44, E52, G01working papers series
Date posted: November 25, 2011
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