Staff Reports
Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission
April 2015 Number 724
Revised November 2017 
JEL classification: E52, E58, G20

Authors: Dong Beom Choi, Thomas M. Eisenbach, and Tanju Yorulmazer

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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