Interest Rate Rules Under Financial Dominance

39 Pages Posted: 26 May 2015

See all articles by Vivien Lewis

Vivien Lewis

Research Centre; KU Leuven

Markus Roth

Deutsche Bundesbank

Multiple version iconThere are 2 versions of this paper

Date Written: April 22, 2015


In our dynamic stochastic general equilibrium model, capital-constrained entrepreneurs finance risky projects by borrowing from banks. Banks make loans using equity and deposits. Because financial contracts are non-state-contingent, bank balance sheets are exposed to entrepreneurial defaults. 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 stabilising debt and monetary policy is subject to 'financial dominance'. Under a constant bank capital requirement, a strong reaction of the interest rate to inĂ¡ation destabilises the financial sector.

Keywords: bank capital, financial dominance, interest rate rule, macro-prudential policy, Taylor Principle

JEL Classification: E32, E44, E52, E58, E61

Suggested Citation

Lewis, Vivien and Roth, Markus, Interest Rate Rules Under Financial Dominance (April 22, 2015). Available at SSRN: or

Vivien Lewis (Contact Author)

Research Centre ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431

KU Leuven ( email )

Oude Markt 13
Leuven, 3000

Markus Roth

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431

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