Money on the Sidelines? The Role of Costly Search and Weak Loan Demand in the Slow Recovery.
The Great Recession featured a large build-up of excess reserves by US banks. Money was sitting on the sidelines rather than being loaned. This paper explores how weak loan demand produced this phenomenon. I embed the New Keynesian model with novel financial frictions that slow the flow of bank funds to the private sector via a search and matching mechanism for long-term loans. Costly search generates a credit spread while imperfect matching produces an excess of liquid funds that banks divert to marketable securities in equilibrium. This structure generates a novel firm-level investment and loan search trade-off where these are complements during periods of high investment productivity and substitutes in response to financial shocks. Utilizing Bayesian estimation methods, I fit the DSGE model to both real and financial time series, adding marketable securities and a credit spread as observables. The model provides a rich business cycle narrative of the Great Recession as elucidated with model simulations. As in prior recessions, productivity contractions preceded the downturn, however, negative financial shocks then amplified the growth slowdown. The finnancial shocks quickly reverse and are followed by persistently low levels of investment efficiency, both in the contraction phase and the early recovery phase. That absence of good investment projects and wide credit spreads produced weak loan demand, consistent with bank-level surveys.
Velocity Targeting at the Zero Lower Bound
I calculate the implied nominal interest rate target for the period after 2007 from an efficient GMM estimation of the Clarida, Gali and Gertler (2000) variant of the Taylor Rule estimated over the period 1979 to 2007. Using this, I am able to show that the target nominal rate has a small but statistically and economically significant effect on money velocity over the post-2007 period which corresponds to the zero lower bound experience in the US. The Fed appears to be targeting money velocity in order to implement its monetary policy objectives, thus overcoming the constraint of the zero lower bound.