Fixed-Rate Loans and the Effectiveness of Monetary Policy

Abstract

Fixed-rate loans may contribute to financial stability because they lower the volatility of interest rates. This reduced volatility of interest rates, however, may undermine the effectiveness of monetary policy. Fixed-rate loans, also, may change the steady-states of economy because fixed interest rates are usually higher than variable interest rates, which can alter incentives of borrowers for loans. This paper tests how fixed-rate loans affect the steady-states of economy and the effectiveness of monetary policy, using the DSGE model. The steady-states in the economy are shown to vary in the ratio of fixed-rate loans. When the ratio of fixed-rate loans rises, borrowers bear more burden of interests because fixed interest rates are higher than variable interest rates. Therefore, borrowers reduce their loans, which lead into decreased weight of financial sector in the economy. Total output, however, remains almost unchanged regardless of the ratio of fixed-rate loans because households increase labor supply to compensate for their financial losses. The similar phenomenon happens when the mark-up of fixed interest rates over variable interest rates increases. Effects of fixed-rate loans on monetary policy turn out to be different in financial economy and real economy. Financial economy variables, such as interest rates and loans, respond differently to monetary policy shocks when the ratio of fixed-rate loans increases. These differences, however, are offset by each other within financial economy and not transmitted to real economy. That is, real economy variables, such as output, consumption, and price, react virtually the same to monetary policy shocks regardless of the ratio of fixed-rate loans. The same results occur when I vary the mark-up of fixed interest rates or the stickiness of fixed interest rates.