Low monetary policy rates lower the cost of capital for firms, thereby spurring productive investment. Low interest rates however can also induce the private sector to enter into risky carry trades when they imply that the earned carry more than offsets liquidity risk. Such carry trades and productive investment compete for funds, so much so that the former may crowd out the latter. Below an endogenous lower bound, monetary easing generates only limited capital expenditures that come at the cost of large and destabilizing financial risk-taking. Absent the ability to regulate carry trades, monetary easing must be complemented with a restrictive emergency-lending policy in the form of higher lending rates so as to discourage risk-taking by relatively illiquid firms. Monetary easing, tepid investment response, and rollover risk for liquid firms then arise jointly (and optimally) in equilibrium.

Central bank balance sheet expansion, through actions like quantitative easing, is run through commercial banks. While this increases liquid central bank reserves held on commercial bank balance sheets, demandable uninsured deposits issued to finance the reserves also increase. Subsequent shrinkage in the central bank balance sheet may entail shrinkage in bank‐held reserves without a commensurate reduction in deposit claims. Furthermore, during episodes of liquidity stress, when many claims on liquidity are called, surplus banks may hoard reserves. As a result, central bank balance sheet expansion may create less additional liquidity than typically thought, and indeed, may increase the probability and severity of episodes of liquidity stress.

A two-sided “credit-line channel”—relating to drawdowns and repayments—explains the severe drop and partial subsequent recovery in bank stock prices during the COVID-19 pandemic. Banks with greater exposure to undrawn credit lines saw larger stock price declines but performed better outside of crises periods. Despite deposit inflows, high drawdowns led to reduced bank lending, suggestive of capital encumbrance upon drawdowns. Repayments of credit lines unencumbered capital which explains the stock price recovery starting Q2 2020. Bank provision of credit lines resembles writing put options on aggregate risk, and we propose how to incorporate this feature into bank stress tests.

We show that “zombie credit”—subsidized credit to nonviable firms—has a disinflationary effect. By keeping these firms afloat, zombie credit creates excess aggregate supply, thereby putting downward pressure on prices. Granular European data on inflation, firms, and banks confirm this mechanism. Markets affected by a rise in zombie credit experience lower firm entry and exit, capacity utilization, markups, and inflation, as well as a misallocation of capital and labor, which results in lower productivity, investment, and value added. If weakly capitalized banks were recapitalized in 2009, inflation in Europe would have been up to 0.21 percentage points higher post‐2012.