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

Goodhart, Charles A.E., Tsomocos, Dimitrios P. and Wang, Xuan (2023) Bank credit, inflation, and default risks over an infinite horizon. Journal of Financial Stability, 67. ISSN 1572-3089

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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 for 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:	Article
Official URL:	https://www.sciencedirect.com/journal/journal-of-f...
Additional Information:	© 2023 The Author(s)
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 Jul 2023 15:57
Last Modified:	25 Apr 2024 17:30
URI:	http://eprints.lse.ac.uk/id/eprint/119771

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