Interest Rate Rules Under Financial Dominance

In our dynamic stochastic general equilibrium model, capital-constrained entrepreneurs finance risky projects by borrowing from banks. Banks make loans using equity and deposits. Because financial contracts are non-state-contingent, bank balance sheets are exposed to entrepreneurial defaults. Macroprudential policy imposes a positive response of the bank capital ratio to lending. Our main result is that the Taylor Principle is violated when this response is too weak. Then macro-prudential policy is ineffective in stabilising debt and monetary policy is subject to ‘financial dominance’. Under a constant bank capital requirement, a strong reaction of the interest rate to inflation destabilises the financial sector.