Working Paper: NBER ID: w28540
Authors: Saki Bigio; Yuliy Sannikov
Abstract: This paper integrates a realistic implementation of monetary policy through the banking system into an incomplete-markets economy with wage rigidity. Monetary policy sets policy rates and alters the supply of reserves. These tools grant independent control over credit spreads and an interest target. Through these tools, monetary policy affects the evolution of real interests rates, credit, output, and the wealth distribution—both in the long and in the short run. We decompose the effects through a combination of the interest and credit channels that depend on the size of the central bank’s balance sheet. Monetary policy reaches an expansionary limit when it enters a liquidity trap. The model highlights a trade-off between worse microeconomic insurance (insurance across agents) and greater macroeconomic insurance (insurance across states). The model prescribes that monetary policy should operate with a small balance sheet which tightens credit during booms, and should expand its balance sheet and lower policy rates during busts.
Keywords: monetary policy; credit; interest rates; liquidity trap
JEL Codes: E31; E32; E41; E42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| supply of reserves (Q31) | credit interest rates (E43) |
| policy rates (E43) | credit interest rates (E43) |
| supply of reserves (Q31) | inflation (E31) |
| policy rates (E43) | inflation (E31) |
| supply of reserves (Q31) | economic activity (E20) |
| policy rates (E43) | economic activity (E20) |
| interest rate on reserves (E43) | credit interest rates (E43) |
| limited supply of reserves (Q31) | credit spread (G19) |
| credit spread (G19) | microeconomic insurance (G52) |
| credit spread (G19) | macroeconomic insurance (E60) |
| reductions in interest on reserves (E43) | loan rates (E43) |