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

42 Pages Posted: 8 Jul 2020 Last revised: 31 Aug 2020

See all articles by Tatjana Schulze

Tatjana Schulze

University of Oxford - Said Business School

Dimitrios P. Tsomocos

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

Date Written: June 15, 2020

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

Suggested Citation

Schulze, Tatjana and Tsomocos, Dimitrios P., The Zero Lower Bound and Financial Stability: A New Role for Central Banks? (June 15, 2020). Available at SSRN: https://ssrn.com/abstract=3627088 or http://dx.doi.org/10.2139/ssrn.3627088

Tatjana Schulze (Contact Author)

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain

HOME PAGE: http://https://www.tatjanaschulze.com/

Dimitrios P. Tsomocos

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)

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