The Zero Lower Bound and Financial Stability: A New Role for Central Banks?

Abstract

Are critics’ concerns for bank profitability a justification for the European Central Bank to raise interest rates from the (zero) lower bound (ZLB)? Using a general equilibrium model with banks and collateral default, we analyze optimal monetary and regulatory policy upon departure from the ZLB. Rather than supporting bank profits, higher interest rates depress inflation when higher debt servicing costs increase losses from default. Precisely these losses offset any gains from banks’ interest margin. Monetary policy operates beyond traditional channels, stressing the relevance of Fisherian debt-deflation forces. They warrant incorporating financial stability objectives into central banks’ objective function.

Keywords: monetary policy & financial stability trade-off, central bank optimization, zero lower bound, bank profitability, default

JEL Classification: E44, E58, G21, G28