Dynamic Consequences of Monetary Policy for Financial Stability

We theoretically investigate the state-dependent effects of monetary policy on macroeconomic instability. In the model, banks borrow using deposits and allocate resources to productive projects. Because banks do not actively issue equity, aggregate outcomes depend on the level of equity in the financial sector. Carefully targeted monetary policy can improve stability by increasing the rate of bank equity growth, and improve allocations by encouraging leverage when intermediation is needed. A fed put is generally stabilizing, but the marginal impact of a rate cut depends on the state of the economy. The effectiveness of monetary policy depends on the extent to which rate cuts pass through to bank returns. When banks are relatively well-capitalized, rate cuts primarily decrease banks' returns. In terms of welfare, the costs of "leaning against the wind" generally outweigh the benefits, but a fed put can improve outcomes if the costs of deviating from the inflation target are sufficiently small.