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Cao, Jin; Illing, Gerhard (2012): \"Interest Rate Trap\", or: Why does the central bank keep the policy rate too low for too long time? CESifo Working Paper: Monetary Policy and International Finance, 3794
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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.