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"Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?

Author

Listed:
  • Jin Cao

    (Norges Bank (Central Bank of Norway))

  • Gerhard Illing

    (University of Munich. Department of Economics)

Abstract
This paper provides a framework for modeling the risk-taking channel of monetary policy, the mechanism how financial intermediaries’ incentives for liquidity transformation are affected by the central bank’s reaction to financial crisis. Anticipating central bank’s reaction to liquidity stress gives banks incentives to invest in excessive liquidity transformation, triggering an "interest rate trap" - the economy will remain stuck in a long lasting period of sub-optimal,low interest rate equilibrium. We demonstrate that interest rate policy as financial stabilizer is dynamically inconsistent, and the constraint efficient outcome can be implemented by imposing ex ante liquidity requirements.

Suggested Citation

  • Jin Cao & Gerhard Illing, 2011. ""Interest rate trap", or: Why does the central bank keep the policy rate too low for too long time?," Working Paper 2011/12, Norges Bank.
    • Handle: RePEc:bno:worpap:2011_12
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    File URL: https://www.norges-bank.no/en/news-events/news-publications/Papers/Working-Papers/2011/WP-201112/
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    References listed on IDEAS

    as
    1. Douglas W. Diamond & Raghuram G. Rajan, 2012. "Illiquid Banks, Financial Stability, and Interest Rate Policy," Journal of Political Economy, University of Chicago Press, vol. 120(3), pages 552-591.
    2. Giavazzi, Francesco & Giovannini, Alberto, 2010. "Central Banks and the Financial System," CEPR Discussion Papers 7944, C.E.P.R. Discussion Papers.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Cao, Jin & Chollete, Loran, 2014. "Capital Adequacy and Liquidity in Banking Dynamics: Theory and Regulatory Implications," UiS Working Papers in Economics and Finance 2014/16, University of Stavanger.
    2. Jin Cao & Loran Chollete, 2013. "Monetary policy and financial stability in the long run," Working Paper 2013/21, Norges Bank.
    3. Ramayandi, Arief & Rawat, Umang & Tang, Hsiao Chink, 2014. "Can Low Interest Rates be Harmful: An Assessment of the Bank Risk-Taking Channel in Asia," Working Papers on Regional Economic Integration 123, Asian Development Bank.
    4. Jin Cao & Lorán Chollete, 2013. "Central Banking and Financial Stability in the Long Run," CESifo Working Paper Series 4272, CESifo.
    5. Lukas Scheffknecht, 2013. "Contextualizing Systemic Risk," ROME Working Papers 201317, ROME Network.

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    More about this item

    Keywords

    Interest rate trap; Risk-taking channel; Systemic risk; Liquidity requirements; Macroprudential regulation;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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