Abstract: We construct a general equilibrium model to illustrate the transmission mechanism of the central bank policy rate after interest rate deregulation. Specially, we focus on how changes of the central bank policy rate could impact other interest rates, including bond yields as well as bank deposit and lending rates. The benchmark model reveals the drivers of the transmission: various economic agents (commercial banks, households, and firms) maximize their profits or minimize their funding costs through optimizing asset allocations in different financial markets when facing policy shocks from the central bank. More importantly, the benchmark model is extended to analyze the impact of various policy restrictions and market frictions (such as the reserve requirement ratio, loan-to-deposit ratio, quantitative restrictions on lending, high issuance and trading costs in the bond market, lack of bond market liquidity, firms’ soft budget constraint, and loan securitization) on interest rate transmission. We find that a high reserve requirement ratio, the existence of the loan-to-deposit ratio, quantitative restrictions on lending, firms’ soft budget constraint and bond market illiquidity may weaken policy rate transmission to other interest rates.
Full report :A Theoretical Model of Policy Rate Transmission.pdf
