Bank Credit and Default in Infinite Horizon

Abstract

Ever since the Great Financial Crisis, if not before, it has become clear that there are complex interactions between the real and nominal sectors of the economy. When do monetary and financial policy goals conflict with each other? When is monetary policy a complement to or a substitute for macroprudential policy? What is the role of money-financed fiscal expansion and its impact on allocations, prices, and financial stability? We develop a dynamic stochastic general equilibrium (DSGE) model featuring deposit issuance via bank credit and endogenous default. We argue that the official policy rate and the financial wedge, namely the spread between loan and deposit rates, are the key variables for the analysis of the interaction between price stability and financial fragility. We show that both the monetary policy rate and the financial wedge exert real effects, even though prices are fully flexible. We establish, first, that contractionary monetary policy is, typically, unable to lean effectively against the wind during periods of financial deregulation; second, that capital requirements often have procyclical effects; third, that monetary policy is more effective when the economy is more liquidity-constrained; and fourth, that money-financed fiscal expansion is effective in raising output and inflation, and accompanied with lower credit risks.