Cleveland Fed & Christopher Waller, Report: On the Essentiality of Credit and Banking at Zero Interest Rates

“Three main results arise from our analysis. First, we find that financial intermediation can improve the allocation at zero interest rates because it relaxes the liquidity constraints of impatient borrowers. Second, changes in credit conditions are not necessarily neutral at zero interest rates in a monetary equilibrium. When the debt limit is low, money and credit are perfect substitutes and tightening the debt limit is neutral. As the debt limit increases, however, patient agents keep holding money, while impatient ones prefer not to. Why? Money is costly for them, since they face a positive shadow interest rate, whereas borrowing is costless at zero interest rates. In that case, increasing the debt limit improves the allocation. Third, the welfare-increasing role of banks differs at positive versus zero interest rates. When interest rates are positive, banks provide liquidity insurance. When interest rates are zero, they relax liquidity constraints owing to their ability to enforce debt repayment.”