Do Bank-Based Financial Systems Reduce Macroeconomic Volatility by Smoothing Interest Rates?

This paper investigates the business cycle implications of limited pass-through to retail interest rates based on a calibrated sticky price model. Although limited interest rate pass-through can in principle reduce output and inflation volatility at the same time, large reductions in output volatility are likely to be accompanied by a more volatile inflation rate. Limited pass-through gives rise to two counteracting effects: It partially insulates the economy from adverse liquidity shocks and thereby leads to lower output volatility. However, it also reduces the stabilizing effect of monetary policy which implies higher inflation volatility.