nep-cba New Economics Papers
on Central Banking
Issue of 2014‒02‒15
fourteen papers chosen by
Maria Semenova
Higher School of Economics

  1. Monetary policy and financial stability: what role in prevention and recovery? By Claudio Borio
  2. The negative feedback loop between banks and sovereigns By Paolo Angelini; Giuseppe Grande; Fabio Panetta
  3. Optimal Monetary Policy with Counter-Cyclical Credit Spreads By Airaudo, Marco; Olivero, María Pía
  4. On the economics of committed liquidity facilities By Morten Bech; Todd Keister
  5. The lender of last resort in court By Winkler, Adalbert
  6. Determinants of the Trilemma Policy Combination By Ito, Hiro; Kawai, Masahiro
  7. Monetary policy shocks and foreign investment income: evidence from a large Bayesian VAR By Auer, Simone
  8. The global long-term interest rate, financial risks and policy choices in EMEs By Philip Turner
  9. A Novel Banking Supervision Method using a Threshold-Minimum Dominating Set By Gogas, Periklis; Papadimitriou , Theophilos; Matthaiou, Maria- Artemis
  10. Indeterminacy and Learning: An Analysis of Monetary Policy in the Great Inflation By Thomas A. Lubik; Christian Matthes
  11. Estimating Interest Rate Setting Behavior in Korea: An Ordered Probit Model Approach By Hyeongwoo Kim
  12. Not all international monetary shocks are alike for the Japanese economy By Ronald A. Ratti; Joaquin L. Vespignani
  13. Government guarantees and bank risk taking incentives By Markus Fischer; Christa Hainz; Jörg Rocholl; Sascha Steffen
  14. Financial Frictions and the Transmission of Foreign Shocks in Chile By Javier García-Cicco; Markus Kirchner; Santiago Justel

  1. By: Claudio Borio
    Abstract: If the criteria for an institution's success are diffusion and longevity, then central banking has been hugely successful. But if the criterion is the degree to which it has achieved its goals, then the evaluation has to be more nuanced. Historically, those goals have included a changing mix of financial and monetary stability. Attaining monetary and financial stability simultaneously has proved elusive across regimes. Edging closer towards that goal calls for incorporating systematically long-duration and disruptive financial booms and busts - financial cycles - in policy frameworks. For monetary policy, this means leaning more deliberately against booms and easing less aggressively and persistently during busts. What is ultimately at stake is the credibility of central banking - its ability to retain trust and legitimacy.
    Keywords: financial cycle, balance sheet recessions, expectations gap, time inconsistency, regime shifts
    Date: 2014–01
  2. By: Paolo Angelini (Banca d'Italia); Giuseppe Grande (Banca d'Italia); Fabio Panetta (Banca d'Italia)
    Abstract: More than three years since the outbreak of the sovereign debt crisis in the euro area the banking systems of several countries remain exposed to the vagaries of government bond markets. The paper analyzes the different channels through which sovereign risk affects banking risk (and vice versa), presents some new evidence on bank-sovereign links, and discusses policy options for addressing the related risks.
    Keywords: sovereign risk, sovereign debt crisis, global financial crisis, banking sector risk, bank regulation, contagion, credit crunch
    JEL: E44 E51 E58 G01 G21 G28 H63
    Date: 2014–01
  3. By: Airaudo, Marco (School of Economics LeBow College of Business Drexel University); Olivero, María Pía (School of Economics LeBow College of Business Drexel University)
    Abstract: We study optimal monetary policy in a New Keynesian-DSGE model where the combination of a credit channel and customer-market features in banking gives rise to counter-cyclical credit spreads. In our setting, monopolistically competitive banks set lending rates in a forward-looking fashion as they internalize the fact that, due to borrowers. bank-specific (hence deep) habits, current interest rates also affect the future demand for loans by financially constrained. In particular, during a phase of economic expansion, banks might find it optimal to lower current lending rates to build up a larger customer base, which will be locked into a long-term relationship. The resulting counter-cyclicality of credit spreads makes optimal monetary policy depart substantially from the efficient allocation (and hence from price stability), under both discretion and commitment. Our analysis shows that the welfare costs of setting monetary policy under discretion (with respect to the optimal Ramsey plan) and of using simpler sub-optimal policy rules are strictly increasing in the magnitude of deep habits in credit markets and market power in banking.
    Keywords: Optimal monetary policy; Cost Channel; New-Keynesian model; Credit frictions; Deep habits; Credit spreads
    JEL: E32 E44 E50
    Date: 2014–01–25
  4. By: Morten Bech; Todd Keister
    Abstract: We study the effects of the new Basel III liquidity regulations in jurisdictions with a limited supply of high-quality liquid assets. Using a model based on Bech and Keister (2013), we show how introducing a liquidity coverage ratio in such settings can have significant side effects, leading to a large liquidity premium and pushing the short-term interest rate to the floor of the central bank's rate corridor. Adding a committed liquidity facility allows the central bank to mitigate these effects. By pricing committed liquidity appropriately, the central bank can determine either the equilibrium liquidity premium or the quantity of liquid assets held by banks, but not both. We argue that the optimal pricing arrangement will depend on local market conditions.
    Keywords: Basel III, liquidity regulation, liquidity premium, liquidity coverage ratio, committed liquidity facility
    Date: 2014–01
  5. By: Winkler, Adalbert
    Abstract: Is the OMT program in violation of the ECB's mandate? This paper applies the economic argumentation put forth by the OMT's opponents and supporters before the Federal German Constitutional Court [Bundesverfassungsgericht] to the full allotment policy practiced by the ECB since October 2008. The comparison shows that if the OMT violates the ECB's mandate, the same holds for the full allotment policy. Ultimately, therefore, the ECB is not in court because of monetary financing, but rather as a lender of last resort. Accordingly, a court decision against the OMT would endorse an economic reasoning which contradicts 150 years of modern central bank history and would expose the euro area to the instabilities of financial markets. Such a monetary union is neither sustainable nor desirable. --
    Keywords: lender of last resort,OMT program,full allotment policy
    JEL: E52 E53 F33
    Date: 2014
  6. By: Ito, Hiro (Asian Development Bank Institute); Kawai, Masahiro (Asian Development Bank Institute)
    Abstract: This paper presents a theoretical framework for policy making based on the “impossible trinity” or the “trilemma” hypothesis. A simple optimization model shows that placing more weight in terms of preference for each of the three open macroeconomic policies—exchange rate stability, financial market openness, and monetary policy independence—contributes to a higher level of achievement in that particular policy. The paper goes on to develop the first empirical framework in the literature to investigate the joint determination of the triad open macroeconomic policies based on the trilemma hypothesis. Results from applying the seemingly unrelated regression estimation method and employing other robustness checks show that simple economic and structural fundamentals determine the trilemma policy combinations. Finally, the paper examines how deviations from the “optimal” trilemma policy combinations evolve around the time of a financial crisis.
    Keywords: trilemma hypothesis; macroeconomic policy; exchange rate stability; financial market openness; monetary policy independence; financial crisis; policy combination
    JEL: F15 F21 F31 F36 F41 O24
    Date: 2014–01–30
  7. By: Auer, Simone (Federal Reserve Bank of Dallas)
    Abstract: This paper assesses the transmission of monetary policy in a large Bayesian vector autoregression based on the approach proposed by Banbura, Giannone and Reichlin (2010). The paper analyzes the impact of monetary policy shocks in the United States and Canada not only on a range of domestic aggregates, trade flows, and exchange rates, but also foreign investment income. The analysis provides three main results. First, a surprise monetary policy action has a statistically and economically significant impact on both gross and net foreign investment income flows in both countries. Against the background of growing foreign wealth and investment income, this result provides preliminary evidence that foreign balance-sheet channels might play an increasingly important role for monetary transmission. Second, the impact of monetary policy on foreign investment income flows differs considerably across asset categories and over time, suggesting that the investment instruments and the currency denomination of a country’s foreign assets and liabilities are potentially relevant for the way in which monetary policy affects the domestic economy. Finally, the results support existing evidence on the effectiveness of large vector autoregressions and the Bayesian shrinkage approach in addressing the curse of dimensionality and eliminating price and exchange rate puzzles.
    JEL: C53 E52 F41 F42
    Date: 2014–02–13
  8. By: Philip Turner
    Abstract: The global long-term interest rate now matters much more for the monetary policy choices facing emerging market economies than a decade ago. The low or negative term premium in the yield curve in the advanced economies from mid-2010 has pushed international investors into EM local bond markets: by lowering local long rates, this has considerably eased monetary conditions in the emerging markets. It has also encouraged much increased foreign currency borrowing in international bond markets by emerging market corporations, much of it by affiliates offshore. These developments strengthen the feedback effects between bond and foreign exchange markets. They also have significant implications for local banking systems.
    Keywords: Term premium, international corporate bonds, monetary policy triangle, currency mismatches
    Date: 2014–02
  9. By: Gogas, Periklis (Democritus University of Thrace, Department of Economics); Papadimitriou , Theophilos (Democritus University of Thrace, Department of Economics); Matthaiou, Maria- Artemis (Democritus University of Thrace, Department of Economics)
    Abstract: A healthy and stable banking system resilient to financial crises is a prerequisite for sustainable growth. Minimization of a) the associated systemic risk and b) of the contagion effect in a banking crisis is a necessary condition to achieve this goal. The Central Bank is in charge of this significant undertaking via a close and detailed monitoring of the banking network that can significantly limit the outbreak of a crisis and a subsequent contagion. In this paper, we propose the use of an auxiliary monitoring system that is both efficient on the required resources and can promptly identify a set of banks that are in distress so that immediate and appropriate action can be taken by the supervising authority. We use the interrelations between banking institutions for efficient monitoring of the entire banking network employing tools from Complex Networks theory. In doing so, we introduce the Threshold Minimum Dominating Set (T-MDS). The T-MDS is used to identify the smallest most efficient subset of banks able to act as a) sensors of distress of a manifested banking crisis and b) provide a path of possible contagion. Moreover, at the discretion of the regulator, the methodology is versatile in providing multiple layers of supervision and monitoring by setting the appropriate threshold levels. We propose the use of this method as a supplementary monitoring tool in the arsenal of a Central Bank. Our dataset includes the 122 largest American banks in terms of their total assets. The empirical results show that when the T-MDS methodology is applied, we can have an efficient supervision of the whole banking network, by monitoring just a small subset of banks. We will show that, the proposed methodology is able to achieve an efficient overview of the 122 banks by only monitoring 47 T-MDS nodes.
    Keywords: Complex networks; Minimum Dominating Set; Banking supervision; Interbank loans
    JEL: D85 E58 G28
    Date: 2014–01–31
  10. By: Thomas A. Lubik; Christian Matthes
    Abstract: We argue in this paper that the Great Inflation of the 1970s can be understood as the result of equilibrium indeterminacy in which loose monetary policy engendered excess volatility in macroeconomic aggregates and prices. We show, however, that the Federal Reserve inadvertently pursued policies that were not anti-inflationary enough because it did not fully understand the economic environment it was operating in. Specifically, it had imperfect knowledge about the structure of the U.S. economy and it was subject to data misperceptions. The real-time data flow at that time did not capture the true state of the economy, as large subsequent revisions showed. It is the combination of learning about the economy and, more importantly, the use of data riddled with measurement error that resulted in policies, which the Federal Reserve believed to be optimal, but when implemented led to equilibrium indeterminacy in the economy.
    Keywords: Federal Reserve, Great Moderation, Bayesian Estimation, Least Squares Learning
    JEL: C11 C32 E52
    Date: 2014–02
  11. By: Hyeongwoo Kim
    Abstract: We investigate the Bank of Korea's interest rate setting behavior using a discrete choice model, where the Monetary Policy Committee revises the target policy interest rate only when the gap between the current market interest rate and the optimal rate exceeds a certain threshold value. Using monthly frequency data since 2000, we evaluate an array of ordered probit models in terms of the in-sample fit. We find important roles for the output gap, inflation, and the won depreciation rate against the US dollar. We also implement out-of-sample forecast exercises with September 2008 (Lehman Brothers Bankruptcy) for a split point, finding good out-of-sample predictability of our models.
    Keywords: Monetary Policy; Bank of Korea; Ordered Probit Model; Target RP Rate; Interbank Call Rate; Taylor Rule
    JEL: E52 E58
    Date: 2014–02
  12. By: Ronald A. Ratti; Joaquin L. Vespignani
    Abstract: It is found that over 1999:1-2012:12 China’s monetary expansion influences Japan through the effect of China’s growth on world commodity prices, increased demand for imports, and exchange rate policy. China’s monetary expansion is associated with significant increases in Japan’s industrial production, exports and inflation, and decreases in the trade-weighted yen. In contrast, U.S. monetary expansion results in contraction in Japan’s industrial production, exports and trade balance (expenditure-switching). Monetary expansion in the Euro area does not significantly affect Japan. Structural vector error correction models are estimated. Results are robust to various contemporaneous restrictions for the effect of international monetary variables, the interaction of foreign and domestic variables and to factor augmented VAR to identify monetary shocks.
    Keywords: International Monetary shocks, Japanese economy, Oil/commodity prices, SVEC models
    JEL: E52 F41 F42 Q43
    Date: 2014–02
  13. By: Markus Fischer (Goethe-Universität Frankfurt am Main); Christa Hainz (ifo Institute for Economic Research); Jörg Rocholl (ESMT); Sascha Steffen (ESMT)
    Abstract: This paper analyzes the effect of the removal of government guarantees on bank risk taking. We exploit the removal of guarantees for German Landesbanken which results in lower credit ratings, higher funding costs, and a loss in franchise value. This removal was announced in 2001, but Landesbanken were allowed to issue guaranteed bonds until 2005. We find that Landesbanken lend to riskier borrowers after 2001. This effect is most pronounced for Landesbanken with the highest expected decrease in franchise value. Landesbanken also significantly increased their off-balance sheet exposure to the global ABCP market. Our results provide implications for the debate on how to remove guarantees.
    Keywords: Government guarantees, exits, risk taking, franchise value, financial crisis, loans
    JEL: G20 G21 G28
    Date: 2014–02–12
  14. By: Javier García-Cicco; Markus Kirchner; Santiago Justel
    Abstract: We set up and estimate a DSGE model of a small open economy to assess the role of domestic financial frictions in propagating foreign shocks. In particular, the model features two types of financial frictions: one in the relationship between depositors and banks (following Gertler and Karadi, 2011) and the other between banks and borrowers (along the lines of Bernanke et al, 1999). We use Chilean data to estimate the model, following a Bayesian approach. We find that the presence of financial frictions increases the importance of foreign shocks in explaining consumption, inflation, the policy rate, the real exchange rate and the trade balance. In contrast, under financial frictions the role of these foreign shocks in explaining output and investment is somehow reduced. The behavior of the real exchange rate and its interaction with the financial frictions is key to understand the results.
    Date: 2014–01

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