Interest Rate Rules Under Financial Dominance

36 Pages Posted: 17 Sep 2018 Last revised: 21 Feb 2019

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: 2018

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.

Keywords: bank capital, financial dominance, interest rate rule, macroprudential policy, Taylor Principle

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

Suggested Citation

Lewis, Vivien and Roth, Markus, Interest Rate Rules Under Financial Dominance (2018). Deutsche Bundesbank Discussion Paper No. 29/2018. Available at SSRN: https://ssrn.com/abstract=3249940

Vivien Lewis (Contact Author)

Research Centre ( email )

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

KU Leuven ( email )

Oude Markt 13
Leuven, 3000
Belgium

Markus Roth

Deutsche Bundesbank ( email )

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

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