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 macroprudential 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 ináation destabilises the financial sector