Towards a Micro-Founded Theory of Monetary Policy

The project deals with the basic economic mechanisms determining how monetary policy affects the economy, in particular how monetary policy affects private investment. It seems that in reality investment reacts much less to changes in the interest rate than one would expect from theory. We investigate some potential ways to reconcile the theory with the empirical results, in particular we look at frictions in labor markets as well as frictions in financial markets.

A second question relates to the optimal regulation of the banking sector, in a world where banks are shouldering a large amount of aggregate risk by issuing long-term debt to companies. How much equity does the banking sector need in order to keep the risk of financial crises reasonably low? Do higher equity requirements also have negative side effects for economic development? Our results show that the tightening of banking regulations in the move from the Basel II to the Basel iII regulations brings a substantial improvement in terms of financial stability. In our model, the Basel III regulations even seem to be close to an optimal policy.