Unconventional monetary policy, financial frictions, and the equity tandem

A key feature of many DSGE frameworks designed to model Quantitative Easing (QE) is that net worth only plays a relevant role on bank's balance sheets. In reality, however, net worth of borrowers and lenders plays a relevant role in financing investment projects. I show that this equity tandem has important implications. Net worth of non-financial firms acts as a first line of defense, since non-financial firm's balance sheets are hit in the first place by real sector shocks. Modeling the equity tandem increases the resilience of the model and, therefore, implies smaller gains of unconventional monetary policy. A novel insight from the simultaneous modeling of borrowers and lenders net worth is that by decreasing the cost of external finance a QE policy is redistributing net worth from banks to non-financial firms. Additionally, considering the reverse operation, a credibly announced Quantitative Tightening (QT), helps to stabilize the spread between the return to capital and the deposit rate during the zero lower bound period. However, different anticipated QT paths are shown to have little consequences for output and inflation.

Automated summary

A key feature of DSGE frameworks designed to model Quantitative Easing (QE) is that they only consider net worth on bank's balance sheets, but in reality, the net worth of borrowers and lenders also plays a relevant role in financing investment projects. The modeling of the equity tandem increases the model's resilience and implies smaller gains from unconventional monetary policy. It also shows that QE redistributes net worth from banks to non-financial firms, and a credibly announced Quantitative Tightening (QT) helps stabilize the spread between capital return and deposit rate.