Watering a lemon tree: heterogeneous risk taking and monetary policy transmission

Abstract: We build a general equilibrium model with financial frictions that impede monetary policy transmission. Agents with heterogeneous productivity can increase investment by levering up, which increases liquidity risk due to maturity transformation. In equilibrium, more productive agents choose higher leverage than less productive agents, which exposes the more productive agents to greater liquidity risk and makes their investment less responsive to interest rate changes. When monetary policy reduces interest rates, aggregate investment quality deteriorates, which blunts the monetary stimulus and decreases asset liquidation values. This, in turn, reduces loan demand, decreasing the interest rate further and generating a negative spiral. Overall, the allocation of credit is distorted and monetary stimulus can become ineffective even with significant interest rate drops.

Keywords: monetary policy transmission; financial frictions; heterogeneous agents; financial intermediation;

JEL Classification: E52; E58; G20;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2015-04-01

Number: 724

Note: Revised April 2020