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Lending Relationships, Banking Crises and Optimal Monetary Policies

Author

Listed:
  • Russell Wong

    (Federal Reserve Bank of Richmond)

  • Cathy Zhang

    (Purdue University)

  • Guillaume Rocheteau

    (University of California, Irvine)

Abstract

This paper develops a dynamic model of lending relationships and monetary policy. Entrepreneurs can finance idiosyncratic investment opportunities through external finance -- by forming lending relationships with banks -- or internal finance -- by accumulating partially liquid assets. We study the dynamic response of lending rates, inflation, and investment to a banking crisis that severs lending relationships. We characterize optimal monetary policy in the aftermath of a crisis and show it involves a positive nominal interest rate that trades off the need to reduce the cost of self insurance by unbanked entrepreneurs and the need to promote the creation of lending relationships with banks. We calibrate the model to the U.S. economy and study quantitatively the optimal policy problem in and out of steady state, with and without commitment by the policymaker.

Suggested Citation

  • Russell Wong & Cathy Zhang & Guillaume Rocheteau, 2017. "Lending Relationships, Banking Crises and Optimal Monetary Policies," 2017 Meeting Papers 152, Society for Economic Dynamics.
    • Handle: RePEc:red:sed017:152
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    References listed on IDEAS

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    3. Adão, Bernardino & Silva, André C., 2020. "The effect of firm cash holdings on monetary policy," European Economic Review, Elsevier, vol. 128(C).

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