Risky lending, bank leverage and unconventional monetary policy

A standard New Keynesian model is extended to include a rich financial system in which financially constrained banks lend to firms and homeowners via defaultable long-term loans. The model generates two endogenous components of interest rate spreads on mortgages and corporate loans: i) a default premium and ii) a liquidity premium. Financial shocks affecting these premiums can reproduce the behavior of several macroeconomic variables during the Great Recession, when we take into account the impact of the zero lower-bound. The model is also used to quantify the effect of the Federal Reserve's purchases of mortgage-backed securities during the last recession. Published by Elsevier B.V.