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

  • Jin Cao

    ()

    (Norges Bank (Central Bank of Norway))

  • Gerhard Illing

    ()

    (University of Munich. Department of Economics)

Registered author(s):

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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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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  1. Douglas W. Diamond & Raghuram Rajan, 2011. "Illiquid Banks, Financial Stability, and Interest Rate Policy," NBER Working Papers 16994, National Bureau of Economic Research, Inc.
  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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