Watering a Lemon Tree: Heterogeneous Risk Taking and Monetary Policy Transmission

Abstract

We build a general equilibrium model with financial frictions that impede monetary policy transmission. Agents with heterogeneous productivity can increase investment by levering up, which increases liquidity risk. In equilibrium, productive agents choose higher leverage, which limits their responsiveness to interest rate changes. A reduction in the interest rate then leads to a deterioration in aggregate investment quality, which decreases liquidation values. This, in turn, reduces loan demand, decreasing the interest rate further and generating a negative spiral. Overall, the allocation of credit is distorted and monetary stimulus can become ineffective even with significant interest rate drops.