Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission

55 Pages Posted: 7 Sep 2017 Last revised: 8 Apr 2020

See all articles by Dong Beom Choi

Dong Beom Choi

Seoul National University - Business School

Thomas M. Eisenbach

Federal Reserve Bank of New York

Tanju Yorulmazer

Koc University

Date Written: April 1, 2020

Abstract

We build a general equilibrium model with financial frictions that impede monetary policy transmission. Agents with heterogeneous productivity can increase investment by levering up, which increases liquidity risk due to maturity transformation. In equilibrium, more productive agents choose higher leverage than less productive agents, which exposes the more productive agents to greater liquidity risk and makes their investment less responsive to interest rate changes. When monetary policy reduces interest rates, aggregate investment quality deteriorates, which blunts the monetary stimulus and decreases asset liquidation values. This, in turn, reduces loan demand, decreasing the interest rate further and generating a negative spiral. Overall, the allocation of credit is distorted and monetary stimulus can become ineffective even with significant interest rate drops.

Keywords: monetary policy transmission, financial frictions, heterogeneous agents, financial intermediation

JEL Classification: E52, E58, G20

Suggested Citation

Choi, Dong Beom and Eisenbach, Thomas M. and Yorulmazer, Tanju, Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission (April 1, 2020). FRB of NY Staff Report No. 724, Available at SSRN: https://ssrn.com/abstract=3029749

Dong Beom Choi (Contact Author)

Seoul National University - Business School ( email )

Seoul
Korea, Republic of (South Korea)

Thomas M. Eisenbach

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-6089 (Phone)

HOME PAGE: http://teisenbach.github.io/

Tanju Yorulmazer

Koc University ( email )

Rumeli Feneri Yolu
Sariyer, Istanbul, 34450
Turkey

HOME PAGE: http://gsssh.ku.edu.tr/en/departments/economics/akademik-kadro/show/tyorulmazer/

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