"Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?
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.
|Date of creation:||21 Nov 2011|
|Date of revision:|
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- Giavazzi, Francesco & Giovannini, Alberto, 2010.
"Central Banks and the Financial System,"
CEPR Discussion Papers
7944, C.E.P.R. Discussion Papers.
- 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.
- Douglas W. Diamond & Raghuram Rajan, 2011. "Illiquid Banks, Financial Stability, and Interest Rate Policy," NBER Working Papers 16994, National Bureau of Economic Research, Inc.
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