DP8652 | A Dynamic General Equilibrium Analysis of Monetary Policy Rules, Adverse Selection and Long-Run Financial Risk

Publication Date

01/11/2011

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Abstract

This paper builds a dynamic general equilibrium macro-finance model with two types of borrowers: entrepreneurs who want to produce and gamblers who want to play a lottery. It links central bank's interest rate policy to expected cash flows of both types. This link enables us to study how the interactions between various shocks and different monetary policy rules affect the borrower pool faced by financial intermediaries. We find that when the economy is hit by an expansionary monetary policy shock, the proportion of entrepreneurs in the borrower pool will be persistently lower than the steady state level after a short period. It is lowest when the central bank does not react to output fluctuations. Quite differently, not reacting to output fluctuations avoids a persistent worsening of the borrower pool in the long run if the shock is a bad productivity shock.