Interest rates, risk, and imperfect markets: puzzles and policies

Traditional theory emphasizes the key role that monetary policycan play through the manipulation of interest rates. But thereare several puzzles that cannot be reconciled with standardmodels. These include: the apparent constancy in interest ratesover extended periods, and changes at other times which appearunrelated to changes in technology and demography; the cyclicalpattern of movements in real interest rates; the impact of nominalnot real interest-rate changes on real variables; and the cyclicalpattern of movements in interest-rate spreads. This paper reachesbeyond the standard competitive equilibrium, perfect information,model of credit markets towards imperfect information models,particularly those that focus on the determinants of bank behaviour.Of the standard models, the money demand model is most deficientin understanding these puzzles. The loanable funds theory anda generalized version of real productivity theory can be reconciledwith imperfect information, and markets and the consequent creditand equity rationing regimes help to explain the puzzles. Specifically,banks may be insensitive to changes in monetary stance owingto risk aversion. There are strong policy implications; it isargued, for instance, that in East Asia raising interest ratesexacerbated economic decline and, rather than contributing toexchange-rate stability, may have induced capital flight asdefault risk increased, lowering risk-adjusted expected returns.