Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/182022
Authors: 
Lewis, Vivien
Roth, Markus
Year of Publication: 
2018
Series/Report no.: 
Bundesbank Discussion Paper 29/2018
Abstract: 
We study the equilibrium properties of a business cycle model with financial frictions and price adjustment costs. Capital-constrained entrepreneurs finance risky projects by borrowing from banks. Banks, in turn, make loans using equity and deposits. Because financial contracts are not contingent on aggregate risk, bank balance sheets are hit when entrepreneurial defaults are higher than expected. Macroprudential policy imposes a positive response of the bank capital ratio to lending. Our main result is that the Taylor Principle is violated when this response is too weak. Then macroprudential policy is ineffective in stabilizing debt and monetary policy is subject to 'financial dominance'. A too aggressive response of the interest rate to inflation can lead to debt disinflation dynamics that destabilize the financial sector.
Subjects: 
bank capital
financial dominance
interest rate rule
macroprudential policy
Taylor Principle
JEL: 
E32
E44
E52
E58
E61
ISBN: 
978-3-95729-487-6
Document Type: 
Working Paper
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