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.