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'Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission'

Detail Summary
Date 24 March 2015
Time 12:30 - 14:00

Abstract:

We build a general equilibrium model with financial frictions that impede the effectiveness of monetary policy in stimulating output. Agents with heterogeneous productivity can increase investment by levering up, but this increases interim liquidity risk. In equilibrium, more productive agents choose higher leverage, invest more and take on higher liquidity risk. Therefore, these agents respond less than the less productive agents to monetary policy reducing the equilibrium interest rate. Overall quality of investment deteriorates, which can generate a negative spiral dampening the effect of a monetary stimulus: Worse overall quality leads to lower liquidation values, increasing the cost of liquidity risk. This reduces the demand for loanable funds, further decreasing the interest rate which leads to further quality deterioration. When this feedback is strong, monetary policy can lose its effectiveness in stimulating aggregate output even if it leads to significant drops in the interest rate (joint with Dong Choi and Tanju Yorulmazer).