Technology shocks, banking sector policy, and the trade-off between firms and households

Abstract

In this paper, we analyse the best possible policy responses for banks facing the possibility of loan default because of an extreme and rare negative productivity shock. We use a finite-period framework with complete information to analyse the impact of such a shock on an economy in the presence of financial frictions, such as sticky deposit rates. Our findings indicate that any recapitalization measure works best in a flexible deposit/lending rate environment for all alternative-saving vehicles, as it leads to better transmission. However, policy interventions to revive economic activity may result in a trade-off between firms’ profit and consumers’ welfare. We, therefore, underline the importance of household welfare, which is augmented by government social expenditure and households’ interest income. Since these may decline due to supply side measures, we note the importance of demand management policies that may help overcome any such welfare effects.