"Interest Rate Trap", or Why Does the Central Bank Keep the Policy Rate Too Low for Too Long?3. (30th June 2015)

• Record Type: Journal Article
• Authors: Cao, Jin; Illing, Gerhard
• Is Part Of: Scandinavian journal of economics. Volume 117:Number 4(2015:Dec.)
• Page Start: 1256
• Page End: 1280
• Publication Date: 2015-06-30
• Subjects: Economics -- Periodicals; 330.05
• DOI: 10.1111/sjoe.12118
• Languages: English
• ISSNs: 0347-0520

Abstract

<abstract abstract-type="main"> <title>Abstract</title> <p>In this paper, we provide a framework for modeling one risk‐taking channel of monetary policy, the mechanism whereby financial intermediaries' incentives for liquidity transformation are affected by the central bank's reaction to a financial crisis. The anticipation of the central bank's reaction to liquidity stress gives banks incentives to invest in excessive liquidity transformation, triggering an "interest rate trap" – the economy will remain stuck in a long‐lasting period of suboptimal, low interest rate equilibrium. We demonstrate that interest rate policy as a financial stabilizer is dynamically inconsistent, and the constrained efficient outcome can be implemented by imposing <italic>ex ante</italic> liquidity requirements.</p> </abstract>