Banks and the State-Dependent Effects of Monetary Policy

This paper provides empirical evidence that contractionary monetary policy is less powerful in high interest-rate environments. We argue that this state dependence reflects the interaction between bank’s net interest margins (the return on banks’ assets minus the per-dollar cost of their funds), and households’ high marginal propensity to consume out of liquid wealth. We construct a banking model in which social dynamics shape household attentiveness to deposit rates and embed it in a nonlinear heterogeneous-agent New Keynesian model. Estimated versions of the partial and general equilibrium models account well for the observed state dependence in the response of banks’ net interest margins and the response of aggregate economic activity to monetary policy shocks.