The Sub-Prime Crisis and UK Monetary Policy
by Christopher Martina and Costas Milasb,c
The “sub-prime” crisis, which led to major turbulence in global financial markets beginning in mid-2007, has posed major challenges for monetary policymakers. We analyze the impact on monetary policy of the widening differential between policy rates and the three-month LIBOR rate, the benchmark for private-sector interest rates. We show that the optimal monetary policy rule should include the determinants of this differential, adding an extra layer of complexity to the problems facing policymakers. Our estimates reveal significant effects of risk and liquidity measures, suggesting that the widening differential between base rates and LIBOR was largely driven by a sharp increase in unsecured lending risk. We calculate that the crisis increased LIBOR by up to 60 basis points; in response, base rates fell further and more quickly than would otherwise have happened as policymakers sought to offset some of the contractionary effects of the sub-prime crisis.
JEL Codes: C51, C52, E52, E58.
(PDF, 26 pages 420 kb)
a Department of Economics, University of Bath
b Economics Group, Keele Management School, Keele University
c Rimini Centre for Economic Analysis, Rimini, Italy