Working Paper: CEPR ID: DP13072
Authors: Viral Acharya; Guillaume Plantin; Pietro Reggiani; Iris Yao
Abstract: Low monetary policy rates lower the cost of capital for firms, thereby spurring productive investment. Low interest rates however can also induce the private sector to enter into risky carry trades when they imply that the earned carry more than offsets liquidity risk. Such carry trades and productive investment compete for funds, so much so that the former may crowd out the latter. Below an endogenous lower bound, monetary easing generates only limited capital expenditures that come at the cost of large and destabilizing financial risk-taking. Absent the ability to regulate carry trades, monetary easing must be complemented with a limited lender-of-last-resort (LOLR) policy in the form of higher lending rates so as to discourage risk-taking by relatively illiquid firms. Monetary easing, tepid investment response, and rollover risk for liquid firms then arise jointly (and optimally) in equilibrium.
Keywords: monetary policy; lender of last resort; financial stability; financial fragility; shadow banking; carry trades; rollover risk
JEL Codes: E52; E58; G01; G21; G23; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low monetary policy rates (E52) | lower cost of capital for firms (G32) |
| lower cost of capital for firms (G32) | spur productive investment (E22) |
| low monetary policy rates (E52) | emergence of risky carry trades (F65) |
| emergence of risky carry trades (F65) | crowd out productive investment (E22) |
| crowd out productive investment (E22) | limited capital expenditures (G31) |
| low monetary policy rates (E52) | increase financial risk-taking (G40) |
| limited capital expenditures (G31) | destabilizing financial risk-taking (F65) |
| absence of regulatory measures (L59) | need for limited LOLR policy (E44) |
| limited LOLR policy (E52) | raises lending rates (G21) |
| raises lending rates (G21) | discourage risk-taking by illiquid firms (G33) |
| monetary easing (E52) | limited capital expenditures (G31) |
| monetary easing (E52) | destabilizing financial risk-taking (F65) |