I study how the secular decline in interest rates affects bank lending and monetary policy transmission. In the model, banks earn deposit and loan spreads, deposits compete with money as a source of liquidity, and banks’ lending capacity is constrained by their equity. A rate cut stimulates lending and output in the short run, but the effect weakens at low rates, long before hitting the ZLB. If the rate decline persists, lending contracts in the long run: lower deposit spreads lead to lower equity and lending, and higher loan spreads. I find support for the model’s predictions in U.S. data.

In this paper, I propose incomplete exchange rate pass-through as a new channel through which balance sheet effects can constrain monetary policy. I consider a New Keynesian open economy with external debt in foreign currency. I first show that absent heterogeneity within the country, outstanding external debt imposes no constraint on monetary policy under complete pass-through. If, however, pass-through is incomplete, then the expenditure switching benefits of a depreciation are weakened, while the strength of debt deflation is unchanged. As a result, sudden stops are contractionary, and prior current account deficits are inefficiently high due to aggregate demand externalities. Optimal macroprudential policy makes the private sector internalize the social value of future exchange rate flexibility. Absent perfect macroprudential tools, monetary policy would like to deter borrowing by promising a large, but time-inconsistent, depreciation during crises. I extend the model to capital flows within currency unions to show how the interaction of goods pricing and debt denomination slowly destroys the option value of exiting the union upon a crisis.

How does market concentration affect the potency of monetary policy? To tackle this question we build a model with oligopolistic sectors. We provide a formula for the response of aggregate output to monetary shocks in terms of sufficient statistics: demand elasticities, concentration, and markups. We calibrate our model to the evidence on pass-through, and find that higher concentration significantly amplifies non-neutrality. To isolate the strategic effects of oligopoly, we compare our model to one with monopolistic competition recalibrated to ensure firms face comparable demand functions. Finally, we compute an exact Phillips curve for our model. Qualitatively, our Phillips curve incorporates extra terms relative to the standard New Keynesian one. However, quantitatively, we show that a standard Phillips curve, appropriately recalibrated, provides an excellent approximation.

We study time-consistent bank resolution mechanisms. When interventions are ex post efficient, a government cannot commit not to inject capital into the banking system. Contrary to common wisdom, we show that the government may still avoid moral hazard and implement the first best allocation by using the distribution of bailouts across banks to provide ex ante incentives. In particular, we analyze properties of credible tournament mechanisms that provide support to the best performing banks and resolve the worst performing ones, including through mergers. Our mechanism continues to perform well if banks are partially substitutable, and if they are heterogeneous in their size, interconnections, and thus systemic risk, as long as bailout funds can be targeted to particular banks.

We build a model with heterogeneous firms and banks to analyze how policy can affect the efficiency of credit allocation and long-term economic outcomes. When transitory demand or productivity shocks are small, conventional monetary policy can restore efficient bank lending and production by lowering interest rates. For moderately large shocks, however, conventional policy may hit the effective lower bound, necessitating unconventional policy such as regulatory forbearance towards banks to stabilize the economy. Aggressive unconventional policy runs the risk of introducing zombie lending and a “diabolical sorting”, whereby low-capitalization banks extend new credit or evergreen existing loans to low-productivity firms. In a dynamic setting, policy aimed at avoiding short-term recessions can be trapped into protracted excessive forbearance due to congestion externalities imposed by zombie lending on healthier firms. The resulting economic sclerosis transforms transitory shocks into phases of delayed recovery and potentially permanent output losses. Our model highlights the importance of maintaining a well-capitalized banking system to avoid such policy traps as not raising capital requirements upfront but raising them significantly upon the arrival of shocks can also backfire by encouraging zombie lending.

We study the transmission of shocks to both the price and the non-price terms of loans in a model of multidimensional contracting between heterogeneous risky borrowers and intermediaries with limited lending capacity. Formulas based on elasticities of loan demand and default rates to interest rates predict how the cross-section of loan terms and banks’ portfolio risk react to changes in lenders’ capital, funding costs and regulation, and borrowers’ risk and liquidity. Our results explain differences in the pass-through of shocks across markets and risk categories in the data. These statistics also drive the dynamic incidence of credit crises through impact and persistence.