nep-cba New Economics Papers
on Central Banking
Issue of 2015‒05‒16
eleven papers chosen by
Maria Semenova
Higher School of Economics

  1. Safeguarding the Banking System - a New Perspective on the Consolidation of the Macroprudential Regulation* By Irina-Raluca Badea
  2. Rewarding Prudence: Risk Taking, Pecuniary Externalities and Optimal Bank Regulation By Kogler, Michael
  3. Optimal Monetary and Fiscal Policy in an Economy with Endogenous Public Debt By Luk, Paul; Vines, David
  4. Optimal Monetary and Fiscal Policy in an Economy with Inflation Persistence By Luk, Paul; Vines, David
  5. Uncovered Interest Parity and Monetary Policy Near and Far from the Zero Lower Bound By Menzie D. Chinn; Yi Zhang
  6. How Can an Economy Protect Itself from the Developed Economies’ Monetary Policy? By Hock Ann Lee; Hock Tsen Wong; Huay Huay Lee
  7. Central bank purchases of government bonds By Samuel Huber; Jaehong Kim
  8. Sovereign Debt and Structural Reforms By Müller, Andreas; Storesletten, Kjetil; Zilibotti, Fabrizio
  9. Market Structure and Exchange Rate Pass-Through By Auer, Raphael; Schoenle, Raphael
  10. The Intrafirm Complexity of Systemically Important Financial Institutions By Robin L. Lumsdaine; Daniel N. Rockmore; Nicholas Foti; Gregory Leibon; J. Doyne Farmer
  11. Does Regulation Matter? Riskiness in Pension Asset Allocation By Sandra Rigot

  1. By: Irina-Raluca Badea (University of Craiova, Faculty of Economics and Business Administration)
    Abstract: The aftermath of the global financial crisis revealed the weaknesses of the financial system and the monetary incentives to be taken into consideration by the policy-makers. Whether it is exposed to specific risks or to systemic risk, the banking system has to be heavily regulated in order to prevent it from collapsing. The macroprudential regulation promotes the stability of the financial system as a whole, and also treats systemic risk as a trigger of a chain reaction caused by the interlinkages in the financial system. Therefore, this paper outlines the role of the macroprudential regulation for achieving the financial stability goal in the context of systemic turbulences. The safeguarding of financial stability should not be understood as a zero tolerance of bank failures or of an avoidance of market volatility but it should avoid financial disruptions that lead to real economic costs.On the one hand, an overlook on the progress of the prudential regulation points out the procyclical aspects of the regulatory requirements so far, such as capital requirements, risk assessment, provisioning; on the other hand, the present paper identifies the improvements of the most recent recommendations on banking regulations, embodied in the Basel III Accord. Hence, the Basel III requirements in terms of capital adequacy, liquidity, the capital and conservation buffers against procyclicality represent unquestionable improvements for the macroprudential regulation. Given the fact that Basel III has established phase-in arrangements from 2013 to 2019, it is important to analyze the progress of its implementation and its impact on the banking system resilience. *This work was cofinanced from the European Social Fund through Sectoral Operational Programme for Human Resources Development 2007-2013, under the project number POSDRU/159/1.5/S/140863 with the title „ Competitive Researchers in Europe in the Field of Humanities and Socio –Economic Sciences. A Multi-regional Research Network”.
    Keywords: financial stability, systemic risk, banking system, Basel III requirements, regulation
    JEL: E52 E58 G01
  2. By: Kogler, Michael
    Abstract: This paper provides a new rationale for macroprudential regulation and studies its optimal design, implementation, and distributional consequences. In a partial equilibrium model where bank risk taking is subject to moral hazard, we show that although private contracting can solve the bank's agency (i.e., risk shifting) problem, the market outcome is constrainedinefficient: The combination of moral hazard and competition for deposits that are not supplied elastically leads to a pecuniary externality as raising deposits ultimately increases the deposit rate and exacerbates risk shifting of all other banks. As a result, banks are too large, have too much leverage, and take excessive risk. This generic inefficiency provides a strong rationale for regulation even in the absence of classical frictions such as social cost of bank failure or incorrectly priced deposit insurance. The pecuniary externality can be internalized by standard regulatory tools such as capital requirements or by issuing a specific number of banking licenses. Related to the idea of financial restraint, optimal regulation creates rent opportunities to reward prudent banks. This also leads to redistribution from depositors to banks and firms with access to the capital market such that optimal regulation is not a Pareto improvement.
    Keywords: Bank Regulation, Bank Competition, Risk Taking, Moral Hazard
    JEL: D60 D62 G21 G28
    Date: 2015–05
  3. By: Luk, Paul; Vines, David
    Abstract: This paper uses a New Keynesian framework to study the coordination of fiscal and monetary policies, in response to an inflation shock when the policymaker acts with commitment. We first show that, in the simplest New Keynesian model, fiscal policy plays no part in the optimal policy response, because of the comparative advantage which monetary policy has in the control of inflation. We then add endogenous public debt and show that the above result is no longer true. When the initial stock of debt is low, it is optimal for government spending to remain largely inactive, but when the initial stock of debt is high, government spending should play a significant stabilisation role in the first period. This finding is robust to adding endogenous capital accumulation and inflation persistence in the Phillips curve.
    Keywords: fiscal policy; government debt; monetary policy; New Keynesian model
    JEL: E4 E5 E6
    Date: 2015–05
  4. By: Luk, Paul; Vines, David
    Abstract: This paper studies a simple New-Keynesian model of fiscal and monetary policy coordination when the policymaker acts under commitment. With a New Keynesian Phillips curve it is optimal to control inflation only through the use of monetary policy. But, when price-setters use a Steinsson (2003) Phillips curve, fiscal policy plays an active role, enabling a greater degree of consumption smoothing.
    Keywords: fiscal policy; monetary policy; New Keynesian model; Phillips curve
    JEL: E4 E5 E6
    Date: 2015–05
  5. By: Menzie D. Chinn; Yi Zhang
    Abstract: Relying upon a standard New Keynesian DSGE, we propose an explanation for two empirical findings in the international finance literature. First, the unbiasedness hypothesis – the proposition that expost exchange rate depreciation matches interest differentials – is rejected much more strongly at short horizons than at long. Second, even at long horizons, the unbiasedness hypothesis tends to be rejected when one of the currencies has experienced a long period of low interest rates, such as in Japan and Switzerland. Using a calibrated New Keynesian dynamic stochastic general equilibrium model, we show how a monetary policy rule can induce the negative (positive) correlation between depreciation and interest differentials at short (long) horizons. The tendency to reject unbiasedness for Japan and Switzerland even at long horizons we attribute to the interaction of the monetary reaction function and the zero lower bound.
    JEL: E12 F21 F31 F41 F47
    Date: 2015–05
  6. By: Hock Ann Lee (Universiti Malaysia Sabah); Hock Tsen Wong (Universiti Malaysia Sabah); Huay Huay Lee (University of Multimedia)
    Abstract: In theory, countries with floating exchange rates and perfect capital mobility should have monetary independence. At the other extreme, countries with pegged exchange rates may completely lose monetary independence. This is the open-economy trilemma. Countries are not possible to combine exchange rate stability, capital mobility and monetary independence. However, previous research on the effects of the choice of exchange rate regime on monetary independence has found mixed results. Given a large set of countries, their different country characteristics such as the level of economic development may have an impact on the interest rate pass-through. In explaining the link between economic development and interest rate pass-through, business cycle synchronization could be one of the plausible reasons. If a country’s business cycle is highly synchronized with foreign countries, its domestic interest rates may be highly correlated with foreign interest rates, even for countries with floating exchange rates. This complicating factor has been ignored in previous work. Thus, this study aims to re-examine this issue by incorporating the level of economic development. In doing so, this study has distinguished more developed from less developed countries. Using panel data analyses, this study uses a sample of more than 100 countries from 1995. The dataset comprises interest rates and the indicators of exchange rate regime, capital control and economic development. This study uses interest rate pass-through as the appropriate measure of monetary independence. The findings show that pegged exchange rates with no capital controls have lower monetary independence than all other regimes. In line with the theory, this study has indicated that countries will completely lose their monetary independence only if their exchange rates are rigidly pegged without capital controls. More importantly, the findings have further confirmed that the evidence of the trilemma did not differ according to sub-groups of similar level of economic development.
    Keywords: Monetary Independence, Exchange Rate Regime, the Open-Economy Trilemma
    JEL: F41
  7. By: Samuel Huber; Jaehong Kim
    Abstract: We develop a microfounded model, where agents have the possibility to trade money for government bonds in an over-the-counter market. It allows us to address important open questions about the effects of central bank purchases of government bonds, these being: under what conditions these purchases can be welfare-improving, what incentive problems they mitigate, and how large these effects are. Our main finding is that this policy measure can be welfare-improving, by correcting a pecuniary externality. Concretely, the value of money is increased as central bank's purchases of government bonds induce agents to increase their demand for money, which is welfare-improving.
    Keywords: Monetary theory, over-the-counter markets, quantitative easing, money demand, pecuniary externality
    JEL: E31 E40 E50 G12
    Date: 2015–04
  8. By: Müller, Andreas; Storesletten, Kjetil; Zilibotti, Fabrizio
    Abstract: Motivated the European debt crisis, we construct a tractable theory of sovereign debt and structural reforms under limited commitment. The government of a sovereign country which has fallen into a recession of an uncertain duration issues one-period debt and can renege on its obligations by suffering a stochastic default cost. When faced with a credible default threat, creditors can make a take-it-or-leave-it debt haircut offer to the sovereign. The risk of renegotiation is reflected in the price at which debt is sold. The sovereign government can also do structural policy reforms that speed up recovery from the recession. We characterize the competitive equilibrium and compare it with the constrained efficient allocation. The equilibrium features increasing debt, falling consumption, and a non-monotone reform effort during the recession. In contrast, the constrained optimum yields step-wise increasing consumption and step-wise decreasing reform effort. Markets for state-contingent debt alone do not restore efficiency. The constrained optimum can be implemented by a flexible assistance program enforced by an international institution that monitors the reform effort. The terms of the program are improved every time the country poses a credible threat to leave the program unilaterally without repaying the outstanding loans.
    Keywords: austerity programs; debt overhang; default; European debt crisis; fiscal policy; Great Recession; Greece; International Monetary Fund; limited commitment; moral hazard; renegotiation; risk premia; sovereign debt; structural reforms
    JEL: E62 F33 F34 F53 H12 H63
    Date: 2015–05
  9. By: Auer, Raphael; Schoenle, Raphael
    Abstract: We study firm-level pricing behavior through the lens of exchange rate pass-through and provide new evidence on how firm-level market shares and price complementarities affect pass-through decisions. Using micro-data from U.S. import prices, we identify two facts: First, exactly the firms that react the most with their prices to changes in their own costs are also the ones that react the least to changing competitor prices. Second, the response of import Prices to exchange rate changes is U-shaped in market share while it is hump-shaped in response to competitor prices. We show that both facts are consistent with a model based on Dornbusch (1987) that generates variable markups through a nested-CES demand system. Finally, based on the model, we find that direct cost pass-through and price complementarities play approximately equally important roles in determining pass-through but also partly offset each other. This suggests that equilibrium feedback effects in pricing are large. Omission of either channel in an empirical analysis results in a failure to explain how market structure affects price-setting in industry equilibrium.
    Keywords: exchange rate pass-through; price complementarities; price setting; U.S. import prices
    JEL: E3 E31 F41
    Date: 2015–05
  10. By: Robin L. Lumsdaine; Daniel N. Rockmore; Nicholas Foti; Gregory Leibon; J. Doyne Farmer
    Abstract: In November, 2011, the Financial Stability Board, in collaboration with the International Monetary Fund, published a list of 29 "systemically important financial institutions" (SIFIs). This designation reflects a concern that the failure of any one of them could have dramatic negative consequences for the global economy and is based on "their size, complexity, and systemic interconnectedness". While the characteristics of "size" and "systemic interconnectedness" have been the subject of a good deal of quantitative analysis, less attention has been paid to measures of a firm's "complexity." In this paper we take on the challenges of measuring the complexity of a financial institution and to that end explore the use of the structure of an individual firm's control hierarchy as a proxy for institutional complexity. The control hierarchy is a network representation of the institution and its subsidiaries. We show that this mathematical representation (and various associated metrics) provides a consistent way to compare the complexity of firms with often very disparate business models and as such may provide the foundation for determining a SIFI designation. By quantifying the level of complexity of a firm, our approach also may prove useful should firms need to reduce their level of complexity either in response to business or regulatory needs. Using a data set containing the control hierarchies of many of the designated SIFIs, we find that in the past two years, these firms have decreased their level of complexity, perhaps in response to regulatory requirements.
    Date: 2015–05
  11. By: Sandra Rigot (University Paris North)
    Abstract: We investigate the influence of investment regulations on the riskiness and procyclcality of defined-benefit (DB) pension funds' asset allocations. We provide a global comparison of the regulatory framework for public, corporate and industry pension funds in the US, Canada and the Netherlands. Derived from panel data analysis of a unique set of close to 600 detailed funds’ asset allocations, our results highlight that regulatory factors are vitally important – more so than the funds’ individual and institutional characteristics, in shaping these asset allocations. In particular, risk-based capital requirements, balance sheet recognition of unfunded liabilities, lower liability discount rates, and shorter recovery periods lead pension funds to decrease their asset allocation to risky assets. Risk-based capital requirements reduce overall risky asset allocation by as much as 5%, but they do not affect the asset classes identically. While equities, real estate and mortgages are at a disadvantage, high yield bonds and commodities are slightly favored.
    Keywords: Solvency, Pension funds, Defined Benefit, Liability discount rate, Valuation requirements, Financial stability, Regulation
    JEL: G28 G11

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