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"Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?

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Author Info

  • Jin Cao

    ()
    (Norges Bank (Central Bank of Norway))

  • Gerhard Illing

    ()
    (University of Munich. Department of Economics)

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Abstract

This paper provides a framework for modeling the risk-taking channel of monetary policy, the mechanism how financial intermediaries’ incentives for liquidity transformation are affected by the central bank’s reaction to financial crisis. Anticipating central bank’s reaction to liquidity stress gives banks incentives to invest in excessive liquidity transformation, triggering an "interest rate trap" - the economy will remain stuck in a long lasting period of sub-optimal,low interest rate equilibrium. We demonstrate that interest rate policy as financial stabilizer is dynamically inconsistent, and the constraint efficient outcome can be implemented by imposing ex ante liquidity requirements.

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File URL: http://www.norges-bank.no/en/Published/Papers/Working-Papers/2011/WP-201112/
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Bibliographic Info

Paper provided by Norges Bank in its series Working Paper with number 2011/12.

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Length: 26 pages
Date of creation: 21 Nov 2011
Date of revision:
Handle: RePEc:bno:worpap:2011_12

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Related research

Keywords: Interest rate trap; Risk-taking channel; Systemic risk; Liquidity requirements; Macroprudential regulation;

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References

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  1. Douglas W. Diamond & Raghuram G. Rajan, 2012. "Illiquid Banks, Financial Stability, and Interest Rate Policy," Journal of Political Economy, University of Chicago Press, vol. 120(3), pages 552 - 591.
  2. Francesco Giavazzi & Alberto Giovannini, 2010. "Central Banks and the Financial System," NBER Working Papers 16228, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Lukas Scheffknecht, 2013. "Contextualizing Systemic Risk," ROME Working Papers 201317, ROME Network.
  2. Jin Cao & Lorán Chollete, 2013. "Central Banking and Financial Stability in the Long Run," CESifo Working Paper Series 4272, CESifo Group Munich.

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