Working Paper: CEPR ID: DP18042
Authors: Charles Goodhart; Dimitrios P. Tsomocos; Xuan Wang
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.
Keywords: corporate default; liquidity creation; inside money; deposits; reserve management; long-run non-neutrality; money-financing; financial intermediation wedge
JEL Codes: E41; E44; E51; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tightening bank capital requirements (G28) | Disinflationary pressures (E31) |
| Monetary expansions (E49) | Generate inflation (E31) |
| Disconnect between financial wedge and policy rate (E43) | Obstruct monetary expansions from generating inflation (E31) |
| Money-financed fiscal expansions (E62) | Improve output (Y60) |
| Money-financed fiscal expansions (E62) | Reduce default risks (G33) |
| Money-financed fiscal expansions (E62) | Increase inflation (E31) |
| Decrease in policy rate (E52) | Decrease in financial wedge (G59) |
| Decrease in financial wedge (G59) | Increase in output (E23) |
| Decrease in financial wedge (G59) | Increase in price levels (E31) |
| 0.25 percentage point decrease in policy rate (E43) | 0.14% increase in quarterly output (E23) |