Monetary Policy and Credit Supply Adjustment with Endogenous Default and Prepayment

Abstract

This paper develops a general-equilibrium model to study how the credit supply mechanisms in the financial intermediation sector, which lends to households and entrepreneurs subject to financial frictions, influence monetary policy. In the model, endogenous default of mortgage and business loans and prepayment of household mortgages influence the costs of supplying credit from the financial intermediary (FI). The FI optimizes its loan portfolio composition given these cost variations with frictions. The loan contracts between the FI and borrowers allow these two parties to share aggregate risk, deviating from the canonical work by Bernanke et al. (1999). I estimate the model with U.S. data. Likelihood inference indicates positive credit supply cost elasticities, significant frictions to portfolio adjustment, and balance-sheet strength fluctuation to borrowers' default and prepayment variations. Given households' endogenous behaviors, conventional monetary policy's effectiveness in stabilizing inflation is enhanced under a TFP shock but reduced under a mortgage loan risk shock, and the credit supply channels worsen the latter situation. The effectiveness of unconventional monetary policy is enhanced by the credit supply channel.

Keywords: E02, E32, E44, E52, E58, G21, DSGE model, Financial intermediation, Financial Frictions, Housing, Bayesian estimation, Monetary policy

JEL Classification: E02, E32, E44, E52, E58, G21