Reaching for Yield and the Diabolic Loop in a Monetary Union

Sabri Boubaker, Dimitrios Gounopoulos, Duc Nguyen, Nikos Paltalidis

Research output: Contribution to journalArticle

Abstract

We build on Acharya and Naqvi (2019) to introduce a macro-financial model where the “reach for yield” incentivized by a loosening monetary policy in the United States miti-gates the diabolic loop in a Monetary Union. We provide empirical evidence that the in-troduction of an accommodative monetary policy by the Fed lowers the yields in US as-sets, increases liquidity and by extension the threshold above which a liquidity shock can damage a bank. This, in turn, incentivizes bank managers to optimize their portfoli-os by investing in risky assets. We use a monetary VAR to provide novel empirical evi-dence that there is an increase in the flow of funds to European assets, a result which can be attributed to the “reach for yield” incentive. This portfolio balance channel attenuates the effects of financial fragility, improves government funding costs, and credit condi-tions by providing liquidity to domestic banks and assets. As a result, the “reaching for yield” incentive mitigates the diabolic loop effect.
Original languageEnglish
Number of pages42
JournalJournal of International Money and Finance
Early online date11 Feb 2020
Publication statusE-pub ahead of print - 11 Feb 2020

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