A Model of Credit, Money, Interest and Prices

Monetary policy affects everyone's life by affecting our ability to borrow and lend and, thus, our decisions to consume and invest. Monetary policy is enacted through operations of central banks such as the Federal Reserve Bank in the United States. The operations of the Federal Reserve impacts bank decisions and therefore the credit markets. This research project develops a model to examine how monetary policy affects bank lending decisions. The model looks at how the difference between lending and borrowing rates can be influenced by monetary policies, which in turn impacts borrowers and lenders differently. The main insight is that monetary policy can in general control credit spreads and inflation independently.

The contribution to the frontier of economics is to integrate recent frameworks that study the implementation of monetary policy through banks, into an incomplete-markets economy. Once we conceive that monetary policy operations can control spreads and affect inflation independently, we begin to challenge many preconceived views. For example, although some monetary policy operations are long-run neutral, others are not. It is often thought that monetary policy cannot set monetary aggregates independently from policy rates. Here, monetary aggregates and rates are independent instruments that grant independent control over spreads and inflation. The model can also rationalize several empirical regularities: the presence of a liquidity effect in monetary policy expansion and a higher elasticity for loan rates than deposit rates, to policy changes. Finally, the model highlights a trade-off between the depth of a crisis and the amount of risk-insurance ex-ante, if we think of monetary policy as a macroprudential tool.