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Policy actions by the Federal Reserve during the recent financial crisis often involve recapitalization of banks. This paper offers a theory of the non-neutrality of money for policy actions taking the form of injecting capital into banks via nominal transfers, in an environment where banking frictions are present in the sense that there exists an agency cost problem between banks and their private-sector creditors. The analysis is conducted within a general equilibrium setting with two-sided financial contracting. The authors first show that even with perfect nominal flexibility, the recapitalization policy can have real effects on the economy. They then study the design of the optimal long-run recapitalization policy as well as the optimal short-run policy responses to banking riskiness shocks.
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