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Bank credit, inflation, and default risks over an infinite horizon

Goodhart, C. A. E., Tsomocos, Dimitrios P and Wang, Xuan (2023) Bank credit, inflation, and default risks over an infinite horizon. CEPR Discussion Papers (DP18042). Centre for Economic Policy Research (Great Britain), London, UK.

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Abstract

The financial intermediation wedge of the banking sector used to co-move positively with the federal funds rate, but the post-GFC era saw a disconnect between them. We develop a flexible price dynamic general equilibrium with banks’ liquidity creation to offer an explanation. In a corridor system, the financial wedge and policy rate are shown to co-move, and the pass-through of monetary policy onto both inflation and output obtains. However, the post-GFC floor system obviates the need of the financial wedge to cover the cost of obtaining reserves, so the wedge and the policy rate indeed disconnect in equilibrium; furthermore, we show that the disconnect obstructs monetary expansions from generating inflation. In this environment, tightening bank capital requirement leads to disinflationary pressure. Money-financed fiscal expansions that subsidise non-bank sectors’ borrowing costs improve output and reduce default risks but increase inflation. The model uses banks’ liquidity creation via credit extension to provide a rationale for both the pre-pandemic disinflation and the post-pandemic inflation. The results hold both on the dynamic paths and in the steady state, and the role of money enlarges the Taylor rule determinacy region.

Item Type: Monograph (Discussion Paper)
Official URL: https://cepr.org/publications/discussion-papers
Additional Information: © 2023 The Authors
Divisions: Financial Markets Group
Subjects: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
JEL classification: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E41 - Demand for Money
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy
E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E51 - Money Supply; Credit; Money Multipliers
E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy Formation, Macroeconomic Aspects of Public Finance, Macroeconomic Policy, and General Outlook > E63 - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization
Date Deposited: 19 Apr 2023 13:09
Last Modified: 16 May 2024 12:27
URI: http://eprints.lse.ac.uk/id/eprint/118681

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