Monetary policy shocks in a DSGE model with a shadow banking system

By Fabio Verona, Manuel M. F. Martins and Inês Drumond

http://d.repec.org/n?u=RePEc:por:cetedp:1101&r=dge

This paper is motivated by the recent financial crisis and addresses whether a “too low for too long” interest rate policy may generate a boom-bust cycle. We suggest a model in which a microfounded shadow banking sector is included in an otherwise state-of-the-art DSGE model. When faced with perverse incentives, financial intermediaries within the shadow banking sector can divert a fraction of stockholders’ profits for their own benefits and extend credit at a discounted rate. The model predicts that long periods of accommodative monetary policy do create the preconditions for, but do not cause per se, a boom-bust cycle. Rather, it is the combination of a persistent monetary ease with microeconomic distortions in the financial system that causes a boom-bust.

Thus the Fed can maintain low interest rates as long as the financial sector is efficiently regulated. Are we there?

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