DP18388 Time-varying volatility, financial intermediation and monetary policy
Financial intermediaries actively manage their balance sheets such that leverage is high in low volatility periods and low in times of high volatility. In this paper, we show that this relation has implications for the monetary transmission mechanism. Using a regime-switching vector autoregression, we provide robust evidence that monetary policy increases credit supply, output and investment more in periods of low volatility. An estimated new Keynesian model with endogenous bank leverage is able to replicate this empirical asymmetry. In the model, banks increase leverage when volatility is low, which makes the financial accelerator mechanism more powerful. The estimated output response to a monetary stimulus is more than 50% larger in low volatility periods than in times of high volatility due to the state-dependent financial accelerator. A countercyclical capital requirement could undo most of the asymmetry induced by the cyclical behavior of bank leverage.
