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Optimal Liquidity Provision and Interest Rate Rules: A Tale of Two Frictions

Author

Listed:
  • Paul Levine

    (University of Surrey)

  • Maryam Mirfatah

    (King’s College London)

  • Joseph Pearlman

    (City University)

  • Stylianos Tsiaras

    (Ecole Polytechnique Federale de Lausanne)

Abstract

We study central bank liquidity provisions to the banking sector in a DSGE model estimated for the Euro Area with financial frictions on the supply and demand side of credit. We show that liquidity provisions, as in the ECB’s recent Long Term Refinancing Operations, can be welfare-enhancing or welfare-reducing when both these financial frictions exist. They relax the banks’ leverage constraint and induce banks to provide more credit. This reduces the credit spread facing firms and increases investment, but this comes at the cost of implementing the liquidity policy. We compute a welfare optimized liquidity rule for the central bank responding to output, inflation and the interest rate spread that can increase welfare in comparison with the case of no liquidity provision. Crucially, this result is conditional on a high level of central bank monitoring of the its loanable funds to banks.

Suggested Citation

  • Paul Levine & Maryam Mirfatah & Joseph Pearlman & Stylianos Tsiaras, 2023. "Optimal Liquidity Provision and Interest Rate Rules: A Tale of Two Frictions," School of Economics Discussion Papers 1323, School of Economics, University of Surrey.
    • Handle: RePEc:sur:surrec:1323
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    File URL: https://repec.som.surrey.ac.uk/2023/DP13-23.pdf
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    More about this item

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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