The Reversal Interest Ratet

The reversal interest rate is the rate at which accommodative mon-etary policy reverses and becomes contractionary for lending. We theoretically demonstrate its existence in a macroeconomic model featuring imperfectly competitive banks that face financial frictions. When interest rates are cut too low, further monetary stimulus cuts into banks' profit margins, depressing their net worth and curtail-ing their credit supply. Similarly, when interest rates are low for too long, the persistent drag on bank profitability eventually outweighs banks' initial capital gains, also stifling credit supply. We quantify the importance of this mechanism within a calibrated New Keynesian model. (JEL E12, E32, E43, E44, E52, G21, L25)

Automated summary

The reversal interest rate refers to the rate at which accommodative monetary policy turns contractionary for lending. This study demonstrates its existence in a macroeconomic model with imperfectly competitive banks facing financial frictions. Cutting interest rates too low reduces banks' profit margins, leading to a decrease in their net worth and credit supply. The persistent drag on bank profitability from prolonged low interest rates outweighs their initial capital gains, thus stifling credit supply. The importance of this mechanism is quantified using a calibrated New Keynesian model.