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Interest rate spreads hikes: What lies behind them?

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The 2007–2009 financial turmoil and the euro area sovereign debt crisis that followed were characterized by severe interest rate spread hikes. In recent work we developed a novel general equilibrium model for a small-open euro-area economy, endowed with a rich characterization of the banking system that allows for regulatory capital requirements, defaulted loans and occasionally binding endogenous credit restrictions. In this article, we use our model to offer a model-based explanation of the endogenous mechanisms associated with sharp interest rate increases based on macroeconomic fundamentals. After briefly describing the model, we analyze the concomitant interest rate dynamics and decompose the overall spread into three components: a capital requirements-driven spread, a credit restrictions-driven spread, and a retail-driven spread. Results suggest that defaulted loans and occasionally biding credit restrictions—two of our novel mechanisms—contribute to severely amplify spread hikes under financial disturbances, but play lesser roles under non-financial ones.
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