Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission

Abstract

We build a general equilibrium model with maturity transformation that impedes monetary policy transmission. In equilibrium, productive agents choose higher leverage, exposing themselves to greater liquidity risk, which limits their responsiveness to interest rate changes. A reduction in the interest rate then leads to a deterioration in aggregate investment quality, which blunts the monetary stimulus and decreases liquidation values. This, in turn, reduces loan demand, decreasing the interest rate further and generating a negative spiral. Overall, the allocation of credit is distorted and monetary stimulus can become ineffective even with significant interest rate drops.

Low real rates as driver of secular stagnation: Empirical assessment

“…A related channel is that low real rates and high debts create resource misallocations. Chio et al (2014) formalise this in a general equilibrium model with heterogeneous productivity of agents. If the interest rate falls, the less productive agents start to invest and this diminishes the average quality of investments and thereby potential growth (a proxy of the natural rate).…”

The Bond Lending Channel of Monetary Policy

“…Moreover, there is ample evidence that bank loans are significantly easier to renegotiate than bonds(Gilson, John, and Lang, 1990;Asquith, Gertner, and Scharfstein, 1994;Denis and Mihov, 2003).7 See for exampleRocheteau, Wright, and Zhang (2018),Kiyotaki and Moore (2018) or Altavilla, Burlon, Giannetti, and Holton (2019). Outside of the corporate sector, recent works argue that liquidity management in the financial sector is key for monetary transmission(Bianchi and Bigio, 2014;Drechsler, Savov, and Schnabl, 2018;Choi, Eisenbach, and Yorulmazer, 2015). Moreover,Kaplan, Moll, and Violante (2018) shows that household liquidity constraints drive the effect of monetary policy in a quantitative HANK model.…”