The prime rate-deposit rate spread and macroeconomic shocks

This paper examines the response of the prime rate-deposit rate spread to shocks in real output growth, inflation, and the stance of monetary policy. A simple model of the lending and deposit markets is introduced that provides insight as to howthese macroeconomic factorsmight affect the spread. The paper employs the recently developed technique of generalized impulse response analysis proposed. This method does not impose a priori restrictions as to the relative importanceeachof thevariables intheunderlyingvectorautoregressionmayplayinthetransmission process. Thus, the results provide robust evidence as to the relationship between the prime rate-deposit rate spread and these macroeconomic factors. Specifically, the model suggests and the empirical results confirm that shocks to inflationwiden the spread while unexpected changes in the federal funds rate and real output growth lead to a narrower spread.