Optimal disinflation with bank insolvency: An assessment of New Zealand's monetary policy

Abstract

This paper sets out a theory of optimal disinflation when there is positive probability of bank insolvency through defaults on loan repayments. Defaults arise through unanticipated increases in the interest rate on loans and these lead to borrowers’ inability to service loans with current income. These defaults result in a reduction in the net worth of the banking system and, if large enough, lead to bank insolvency. The central bank seeks to secure a target rate of inflation and must balance the potentially large costs of bank insolvency against the costs of inflation. The model is applied to New Zealand data in the 1987–1993 period with the purpose of assessing the conduct of monetary policy over this period.