Banks and the State-Dependent Effects of Monetary Policy

Abstract We show that the response of banks' net interest margin to a monetary policy shock is state-dependent. After a period of low Federal Funds rates, a contractionary monetary policy shock leads to a significant rise in net interest margins. In contrast, after a period of high Federal Funds rates, a contractionary monetary policy shock leads to a fall in net interest margins. The response of aggregate economic activity displays a similar state-dependency: real GDP, aggregate real consumption, and real investment fall much more sharply when a contractionary policy occurs after a period of low Federal Funds rates compared to a period of high Federal Funds rates. We develop a banking model in which the fraction of households that are attentive to deposit interest rates depends on the level of the interest rate. This fraction varies over time because of social interactions. We embed our banking model in a DSGE model where the aggregate marginal propensity to consume out of liquid wealth is high. The model accounts for the strong state-dependency in the response of the net interest margins and aggregate economic activity to a contractionary monetary policy shock.