Bank Credit, Inflation, and Default Risks over an Infinite Horizon

33 Pages Posted: 4 Dec 2019 Last revised: 16 Feb 2023

See all articles by Charles Goodhart

Charles Goodhart

London School of Economics & Political Science (LSE) - Financial Markets Group

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Xuan Wang

VU University Amsterdam; Tinbergen Institute; University of Oxford - Said Business School

Date Written: September 6, 2022

Abstract

The financial intermediation wedge of the banking sector used to co-move positively with the federal funds rate, but the post-GFC era saw a disconnect between them. We develop a flexible price dynamic general equilibrium with banks’ liquidity creation to offer an explanation. In a corridor system, the financial wedge and policy rate are shown to co-move, and the pass-through of monetary policy onto both inflation and output obtains. However, the post-GFC floor system obviates the need of the financial wedge to cover the cost of obtaining reserves, so the wedge and the policy rate indeed disconnect in equilibrium; furthermore, we show that the disconnect obstructs monetary expansions from generating inflation. In this environment, tightening bank capital requirement leads to disinflationary pressure. Money-financed fiscal expansions that subsidise non-bank sectors’ borrowing costs improve output and reduce default risks but increase inflation. The model uses banks’ liquidity creation of via credit extension to provide a rationale for both the
pre-pandemic disinflation and the post-pandemic inflation. The results hold both on the dynamic paths and in the steady state, and the role of money enlarges the Taylor rule determinacy region.

Keywords: Corporate default, liquidity creation, inside money deposits, reserve management, long-run non-neutrality, money-financing, financial intermediation wedge

JEL Classification: E41, E44, E51, E63

Suggested Citation

Goodhart, Charles A.E. and Tsomocos, Dimitrios P. and Wang, Xuan, Bank Credit, Inflation, and Default Risks over an Infinite Horizon (September 6, 2022). Available at SSRN: https://ssrn.com/abstract=3491217 or http://dx.doi.org/10.2139/ssrn.3491217

Charles A.E. Goodhart

London School of Economics & Political Science (LSE) - Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom
0207 955 7555 (Phone)
0207 242 1006 (Fax)

Dimitrios P. Tsomocos (Contact Author)

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

Xuan Wang

VU University Amsterdam ( email )

De Boelelaan 1105
Amsterdam, ND North Holland 1081 HV
Netherlands

HOME PAGE: http://https://sites.google.com/view/xuan-wang

Tinbergen Institute ( email )

Gustav Mahlerplein 117
Amsterdam, 1082 MS
Netherlands

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain

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