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

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  • Stiglitz, Joseph E

Abstract

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.

Suggested Citation

  • Stiglitz, Joseph E, 1999. "Interest Rates, Risk, and Imperfect Markets: Puzzles and Policies," Oxford Review of Economic Policy, Oxford University Press, vol. 15(2), pages 59-76, Summer.
  • Handle: RePEc:oup:oxford:v:15:y:1999:i:2:p:59-76
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    Cited by:

    1. Caporale, Guglielmo Maria & Cipollini, Andrea & Demetriades, Panicos O., 2005. "Monetary policy and the exchange rate during the Asian crisis: identification through heteroscedasticity," Journal of International Money and Finance, Elsevier, vol. 24(1), pages 39-53, February.
    2. Ferreira, Alex Luiz & Leon-Ledesma, Miguel A., 2007. "Does the real interest parity hypothesis hold? Evidence for developed and emerging markets," Journal of International Money and Finance, Elsevier, vol. 26(3), pages 364-382, April.
    3. Abouwafia, Hashem E. & Chambers, Marcus J., 2015. "Monetary policy, exchange rates and stock prices in the Middle East region," International Review of Financial Analysis, Elsevier, vol. 37(C), pages 14-28.
    4. Chen, Shiu-Sheng, 2006. "Revisiting the interest rate-exchange rate nexus: a Markov-switching approach," Journal of Development Economics, Elsevier, vol. 79(1), pages 208-224, February.
    5. Ahmad Zubaidi Baharumshah & Venus Khim-Sen Liew & Ron Mittelhammer, 2010. "Non-linearities in Real Interest Rate Parity: Evidence from OECD and Asian Developing Economies," Global Economic Review, Taylor & Francis Journals, vol. 39(4), pages 351-364.
    6. Demetriades, Panicos O. & Andrianova, Svetlana, 2005. "Sources and Effectiveness of Financial Development: What We Know and What We Need to Know," WIDER Working Paper Series 076, World Institute for Development Economic Research (UNU-WIDER).
    7. John SERIEUX, 2009. "Partial Dollarization, Exchange Rates, And Firm Investment In Paraguay," The Developing Economies, Institute of Developing Economies, vol. 47(1), pages 53-80.
    8. Bettina Becker & Stephan G Hall, 2005. "Non-Linear Properties of Currency Crises in Emerging Markets," Money Macro and Finance (MMF) Research Group Conference 2005 13, Money Macro and Finance Research Group.
    9. John Muellbauer & Pierre St-Amant & David Williams, 2015. "Credit Conditions and Consumption, House Prices and Debt: What Makes Canada Different?," Staff Working Papers 15-40, Bank of Canada.
    10. Stracca, Livio, 2005. "Liquidity and real equilibrium interest rates: a framework of analysis," Working Paper Series 542, European Central Bank.
    11. Kuper, Gerard H. & Lestano, 2007. "Dynamic conditional correlation analysis of financial market interdependence: An application to Thailand and Indonesia," Journal of Asian Economics, Elsevier, vol. 18(4), pages 670-684, August.
    12. Marcelin, Isaac & Mathur, Ike, 2016. "Financial sector development and dollarization in emerging economies," International Review of Financial Analysis, Elsevier, vol. 46(C), pages 20-32.

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