Interest Rates, Risk, and Imperfect Markets: Puzzles and Policies

Traditional theory emphasizes the key role that monetary policy can play through the manipulation of interest rates. But there are several puzzles that cannot be reconciled with standard models. These include: the apparent constancy in interest rates over extended periods, and changes at other times which appear unrelated to changes in technology and demography; the cyclical pattern of movements in real interest rates; the impact of nominal not real interest-rate changes on real variables; and the cyclical pattern of movements in interest-rate spreads. This paper reaches beyond the standard competitive equilibrium, perfect information, model of credit markets towards imperfect information models, particularly those that focus on the determinants of bank behaviour. Of the standard models, the money demand model is most deficient in understanding these puzzles. The loanable funds theory and a generalized version of real productivity theory can be reconciled with imperfect information, and markets and the consequent credit and equity rationing regimes help to explain the puzzles. Specifically, banks may be insensitive to changes in monetary stance owing to risk aversion. There are strong policy implications; it is argued, for instance, that in East Asia raising interest rates exacerbated economic decline and, rather than contributing to exchange-rate stability, may have induced capital flight as default risk increased, lowering risk-adjusted expected returns. Copyright 1999 by Oxford University Press.