Bank liquidity preference and the investment demand constraint

Abstract

Aggregate bank liquidity preference is postulated to engender an investment demand constraint. This idea is integrated into a stochastic dynamic structural macroeconomic model to study output and inflation fluctuations. The model has two regimes that allows for examining output and inflation adjustments over time given a change in commercial bank mark-up lending rate, quantitative easing and stochastic output shocks. The two financial regimes are: (i) an investment demand constraint regime; and (ii) a bank liquidity trap regime. The time adjustment of output and inflation given a change in mark-up lending rate and monetary easing depends on the financial regime in which the economy finds itself. Adjustments owing to stochastic output shocks do not depend on the financial regime. The nature of the regime is determined by the level of the mark-up lending rate and its strength of adjustment over time relative to the competitive loanable funds rate.