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Watering a lemon tree: heterogeneous risk taking and monetary policy transmission

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We build a general equilibrium model with maturity transformation that impedes monetary policy transmission. In equilibrium, productive agents choose higher leverage, exposing themselves to greater liquidity risk, which limits their responsiveness to interest rate changes. A reduction in the interest rate then leads to a deterioration in aggregate investment quality, which blunts the monetary stimulus and decreases liquidation values. This, in turn, reduces loan demand, decreasing the interest rate further and generating a negative spiral. Overall, the allocation of credit is distorted and monetary stimulus can become ineffective even with significant interest rate drops.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 724.

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Length: 46 pages
Date of creation: 01 Apr 2015
Date of revision: 01 Nov 2017
Handle: RePEc:fip:fednsr:724
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