Monetary Policy Rules, Adverse Selection and Long-Run Financial Risk

This paper constructs a macro-finance model with two types of borrowers: entrepreneurs who engage in productive activities and gamblers who play in lotteries. It links a central bank's interest rate policy to expected cash flows of both types of borrowers. Via this link we study how the interactions between various shocks and different monetary policy rules affect the quality of the borrower pool faced by financial intermediaries. We find that if the economy is hit by an expansionary monetary policy shock, in the long run the proportion of entrepreneurs in the borrower pool will be persistently lower than the steady state level. This worsening of the borrower pool is more serious if the central bank does not react to output fluctuations. By contrast, not reacting to output fluctuations in case of a negative productivity shock avoids a persistent worsening of the borrower pool in the long run