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.
|Number of pages||42|
|Journal||Journal of International Money and Finance|
|Early online date||11 Feb 2020|
|Publication status||E-pub ahead of print - 11 Feb 2020|