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

Author

Listed:
  • Jin Cao

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

  • Gerhard Illing

    () (University of Munich. Department of Economics)

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.

Suggested Citation

  • Jin Cao & Gerhard Illing, 2011. ""Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?," Working Paper 2011/12, Norges Bank.
  • Handle: RePEc:bno:worpap:2011_12
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    File URL: http://www.norges-bank.no/en/Published/Papers/Working-Papers/2011/WP-201112/
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    References listed on IDEAS

    as
    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. Giavazzi, Francesco & Giovannini, Alberto, 2010. "Central Banks and the Financial System," CEPR Discussion Papers 7944, C.E.P.R. Discussion Papers.
    Full references (including those not matched with items on IDEAS)

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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.

    More about this item

    Keywords

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

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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