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Federal Reserve Bank of New York
Staff Reports
Watering a lemon tree: heterogeneous risk taking and monetary policy transmission
Dong Beom Choi
Thomas M. Eisenbach
Tanju Yorulmazer
Abstract

We build a general equilibrium model with maturity transformation that impedes monetary policy transmission. In equilibrium, productive agents choose higher leverage, exposing themselves to greater liquidity risk, which limits their responsiveness to interest rate changes. A reduction in the interest rate then leads to a deterioration in aggregate investment quality, which blunts the monetary stimulus and decreases 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.


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Dong Beom Choi & Thomas M. Eisenbach & Tanju Yorulmazer, Watering a lemon tree: heterogeneous risk taking and monetary policy transmission, Federal Reserve Bank of New York, Staff Reports 724, 01 Apr 2015, revised 01 Nov 2017.
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Keywords: monetary policy transmission; financial frictions; heterogeneous agents; financial intermediation
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