Staff Working Paper No. 752
By Michael Kumhof and Xuan Wang
We develop a New Keynesian model where all payments between agents require bank deposits, bank deposits are created through disbursement of bank loans, and banks face convex lending costs. At the zero lower bound on deposit rates (ZLBD), changes in policy rates affect activity through both real interest rates and banks’ net interest margins (NIMs). At empirically plausible credit supply elasticities, the Phillips curve is very flat at the ZLBD. This is because inflation increases NIMs, credit, deposits, and thereby output, while higher NIMs also dampen inflation by relaxing price setters’ credit rationing constraint. At the ZLBD, monetary policy has far larger effects on output relative to inflation, and inflation feedback rules stabilize output less effectively than rules that also respond to credit. For post-COVID-19 policy, this suggests urgency in returning inflation to targets, caution with negative policy rates, and a strong influence of credit conditions on rate setting.
This version was updated in November 2020.