Bank credit, inflation, and default risks over an infinite horizon
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, t...
| Main Authors: | , , |
|---|---|
| Format: | Journal article |
| Language: | English |
| Published: |
Elsevier
2023
|
| _version_ | 1797111059235995648 |
|---|---|
| author | Goodhart, CAE Tsomocos, D Wang, X |
| author_facet | Goodhart, CAE Tsomocos, D Wang, X |
| author_sort | Goodhart, CAE |
| collection | OXFORD |
| description | 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 for 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 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. |
| first_indexed | 2024-03-07T08:03:25Z |
| format | Journal article |
| id | oxford-uuid:4de43d33-615d-47d0-aeae-3db352a89717 |
| institution | University of Oxford |
| language | English |
| last_indexed | 2024-03-07T08:03:25Z |
| publishDate | 2023 |
| publisher | Elsevier |
| record_format | dspace |
| spelling | oxford-uuid:4de43d33-615d-47d0-aeae-3db352a897172023-10-13T15:46:42ZBank credit, inflation, and default risks over an infinite horizonJournal articlehttp://purl.org/coar/resource_type/c_dcae04bcuuid:4de43d33-615d-47d0-aeae-3db352a89717EnglishSymplectic ElementsElsevier2023Goodhart, CAETsomocos, DWang, XThe 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 for 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 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. |
| spellingShingle | Goodhart, CAE Tsomocos, D Wang, X Bank credit, inflation, and default risks over an infinite horizon |
| title | Bank credit, inflation, and default risks over an infinite horizon |
| title_full | Bank credit, inflation, and default risks over an infinite horizon |
| title_fullStr | Bank credit, inflation, and default risks over an infinite horizon |
| title_full_unstemmed | Bank credit, inflation, and default risks over an infinite horizon |
| title_short | Bank credit, inflation, and default risks over an infinite horizon |
| title_sort | bank credit inflation and default risks over an infinite horizon |
| work_keys_str_mv | AT goodhartcae bankcreditinflationanddefaultrisksoveraninfinitehorizon AT tsomocosd bankcreditinflationanddefaultrisksoveraninfinitehorizon AT wangx bankcreditinflationanddefaultrisksoveraninfinitehorizon |