A Potential Disadvantage of a Low Interest Rate Policy: the Instability of Banks Liquidity

Abstract

This paper joins the strands of literature supporting the idea that monetary policy should consider seriously the behavior of financial institutions. In a number of recent episodes, lowering the interest rate has been ineffective in bringing economies out of unfavorable conditions. We show how a low interest rate policy could have adverse effects that oppose the positive ones for which they are adopted. In particular, banks may choose to finance more risky borrowers who have an higher average return to cancel out the negative effects triggered by a low interest rate on their revenues. This behavior could seriously endanger macroeconomic performances.