nep-cba New Economics Papers
on Central Banking
Issue of 2015‒12‒01
seventeen papers chosen by
Maria Semenova
Higher School of Economics

  1. External shocks, banks and optimal monetary policy in an open economy By Yasin Mimir; Enes Sunel
  2. On the separation of monetary and prudential policy: how much of the pre-crisis consensus remains? By Cecchetti, Stephen G
  3. A Stochastic Dominance Approach to the Basel III Dilemma: Expected Shortfall or VaR? By Chia-Lin Chang; Juan-Ángel Jiménez-Martín; Esfandiar Maasoumi; Michael McAleer; Teodosio Pérez-Amaral
  4. Unconventional Monetary Policy in the Euro Zone By John Driffill
  5. Ambiguity, monetary policy and trend inflation By Masolo, Riccardo; Monti, Francesca
  6. The effect of ECB monetary policies on interest rates and volumes By Jérôme Creel; Paul Hubert; Mathilde Viennot
  7. Inflation dynamics during the financial crisis By Gilchrist, Simon; Schoenle, Raphael; Sim, Jae W.; Zakrajsek, Egon
  8. Reputational Risk Management in Central Banks By Jill Vardy
  9. Interdependence between Sovereign and Bank CDS Spreads in Eurozone during the European Debt Crisis - The PSI Effect By Papafilis, Michalis-Panayiotis; Psillaki, Maria; Margaritis, Dimitris
  10. Should We Worry About Excess Reserves? By Phelan, Christopher
  11. Towards Greater Diversification in Central Bank Reserves By Marie Brière; Valérie Mignon; Kim Oosterlinck; Ariane Szafarz
  12. QE and the Bank Lending Channel in the United Kingdom By Butt, Nick; Churm, Rohan; McMahon, Michael; Morotz, Arpad; Schanz, Jochen
  13. Exit Expectations and Debt Crises in Currency Unions By Alexander Kriwoluzky; G. J. Müller; M. Wolf
  14. US Domestic Money, Output, Inflation and Unemployment By Ackon, Kwabena
  15. Loss-Deviation risk measures By Marcelo Brutti Righi
  16. Monetary Policy and Welfare in a Currency Union By D’Aguanno, Lucio
  17. Sovereign Debt Restructurings: Preemptive or Post-Default By Asonuma, Tamon; Trebesch, Christoph

  1. By: Yasin Mimir; Enes Sunel
    Abstract: We document empirically that the 2007-09 Global Financial Crisis exposed emerging market economies (EMEs) to an adverse feedback loop of capital outflows, depreciating exchange rates, deteriorating balance sheets, rising credit spreads and falling real economic activity. In order to account for these empirical findings, we build a New-Keynesian DSGE model of a small open economy with a banking sector that has access to both domestic and foreign funding. Using the calibrated model, we investigate optimal, simple and operational monetary policy rules that respond to domestic/external financial variables alongside inflation and output. The Ramsey-optimal policy rule is used as a benchmark. The results suggest that such an optimal policy rule features direct and non-negligible responses to lending spreads over the cost of foreign debt, the real exchange rate and the US policy rate, together with a mild anti-inflationary policy stance in response to domestic and external shocks. Optimal policy faces trade-offs in smoothing inefficient fluctuations in the intratemporal and intertemporal wedges driven by inflation, credit spreads and the real exchange rate. In response to productivity and external shocks, a countercyclical reserve requirement (RR) rule used in coordination with a conventional interest rate rule attains welfare levels comparable to those implied by spread- and real exchange rate-augmented rules.
    Keywords: Optimal monetary policy, banks, credit frictions, external shocks, foreign debt
    Date: 2015–11
  2. By: Cecchetti, Stephen G
    Abstract: Prior to the crisis, monetary policymakers and prudential authorities had clearly defined tools and goals with little or no conflict. The crisis revealed a variety of overlaps, where one set of policies seem to influence those in another. Does this mean that two policy realms can no longer remain separate? I address the question by first asking whether monetary policy creates significant financial stability risks. My answer is generally no. Given that, central bankers should refrain from reacting to financial stability risks in most circumstances. Instead, the job of safeguarding the financial system should be left, as it was prior to the crisis, to prudential policymakers. But how can prudential policy best maintain financial stability? I argue that, given our current state of knowledge, stress tests are the best tool to ensure crisis will be rare and not terribly severe. So, my answer to the question in the title is that the pre-crisis consensus remains largely intact.
    Keywords: capital requirements; financial stability policy; monetary policy; prudential policy; stress tests
    JEL: E52 G01 G28
    Date: 2015–11
  3. By: Chia-Lin Chang (Department of Applied Economics Department of Finance National Chung Hsing University Taichung, Taiwan.); Juan-Ángel Jiménez-Martín (Departamento de Fundamentos del Análisis Económico II (Economía Cuantitativa). Universidad Complutense de Madrid.); Esfandiar Maasoumi (Department of EconomicsEmory University, USA); Michael McAleer (Department of Quantitative Finance National Tsing Hua University, Taiwan); Teodosio Pérez-Amaral (Departamento de Fundamentos del Análisis Económico II (Economía Cuantitativa). Universidad Complutense de Madrid.)
    Abstract: The Basel Committee on Banking Supervision (BCBS) (2013) recently proposed shifting the quantitative risk metrics system from Value-at-Risk (VaR) to Expected Shortfall (ES). The BCBS (2013) noted that “a number of weaknesses have been identified with using VaR for determining regulatory capital requirements, including its inability to capture tail risk” (p. 3). For this reason, the Basel Committee is considering the use of ES, which is a coherent risk measure and has already become common in the insurance industry, though not yet in the banking industry. While ES is mathematically superior to VaR in that it does not show “tail risk” and is a coherent risk measure in being subadditive, its practical implementation and large calculation requirements may pose operational challenges to financial firms. Moreover, previous empirical findings based only on means and standard deviations suggested that VaR and ES were very similar in most practical cases, while ES could be less precise because of its larger variance. In this paper we find that ES is computationally feasible using personal computers and, contrary to previous research, it is shown that there is a stochastic difference between the 97.5% ES and 99% VaR. In the Gaussian case, they are similar but not equal, while in other cases they can differ substantially: in fat-tailed conditional distributions, on the one hand, 97.5%-ES would imply higher risk forecasts, while on the other, it provides a smaller down-side risk than using the 99%-VaR. It is found that the empirical results in the paper generally support the proposals of the Basel Committee.
    Keywords: Stochastic dominance, Value-at-Risk, Expected Shortfall, Optimizing strategy, Basel III Accord.
    JEL: G32 G11 G17 C53 C22
    Date: 2015–11
  4. By: John Driffill
    Abstract: The European Central Bank adopted a policy of quantitative easing early in 2015, long after the US and UK, and after implementing a succession of measures to increase liquidity in the Euro zone financial markets, none of which proved sufficient eventually. The paper draws out lessons for the Euro zone from US and UK experience. Numerous event studies have been undertaken to uncover the effects of QE on yields on and prices of financial assets. Estimated effects on long-term government bond yields are then converted into the size of the cut in the policy rate that would normally have been needed to produce them. From these implicit cuts in policy rates, estimates of the effect on GDP and inflation are generated. Euro zone QE appears to have had a much smaller effect on bond yields for the core members states than did QE in the US or UK. Therefore its effects on output and inflation are likely to be proportionately smaller. Its effects on long-term government bond yields in periphery members are greater. QE is compressing interest differential among Euro zone member states. The dangers of QE to which various commentators draw attention, that it creates a danger of inflation in the future, that it creates asset price bubbles, that it allows zombie firms and banks to survive, slowing down the process of adjustment, seem remote. Meanwhile it makes a useful contribution to cutting the costs of debt service and allowing member states more fiscal room for maneouvre.
    Keywords: quantitative easing, unconventional monetary policy, Euro zone, financial crisis, European Central Bank
    JEL: E31 E43 E51 E58 E63
    Date: 2015–11
  5. By: Masolo, Riccardo (Bank of England); Monti, Francesca (Bank of England)
    Abstract: We develop a model that can explain the evolution of trend inflation in the United States in the three decades before the Great Recession as a function of the reduction in uncertainty about the monetary policy maker’s behaviour. The model features ambiguity-averse agents and ambiguity regarding the conduct of monetary policy, but is otherwise standard. Trend inflation arises endogenously and has these determinants: the strength with which the central bank responds to inflation, the degree of uncertainty about monetary policy perceived by the private sector, and, if it exists, the inflation target. Given the importance of monetary policy for the determination of trend inflation, we also study optimal monetary policy in the case of lingering ambiguity.
    Keywords: Ambiguity aversion; monetary policy; trend inflation.
    JEL: D84 E31 E43 E52 E58
    Date: 2015–11–13
  6. By: Jérôme Creel (OFCE); Paul Hubert (OFCE); Mathilde Viennot (École normale supérieure - Cachan)
    Abstract: This paper assesses the transmission of ECB monetary policies, conventional and unconventional, to both interest rates and lending volumes or bond issuance for three types of different economic agents through five different markets: sovereign bonds at 6-month, 5-year and 10-year horizons, loans to non-financial corporations, and housing loans to households, during the financial crisis, and for the four largest economies of the Euro Area. We look at three different unconventional tools: excess liquidity, longer-term refinancing operations and securities held for monetary policy purposes following the decomposition of the ECB’s Weekly Financial Statements. We first identify series of ECB policy shocks at the Euro Area aggregate level by removing the systematic component of each series and controlling for announcement effects. We second include these exogenous shocks in country-specific structural VAR, in which we control for the credit demand side. The main result is that only the pass-through from the ECB rate to interest rates has been effective. Unconventional policies have had uneven effects and primarily on interest rates.
    Keywords: Transmission channels; Unconventional Monetary Policy; Quantitative Easing; Pass through; Bank lending
    JEL: E51 E52 E58
    Date: 2015–10
  7. By: Gilchrist, Simon (Boston University and NBER); Schoenle, Raphael (Brandeis University); Sim, Jae W. (Federal Reserve Board of Governors); Zakrajsek, Egon (Federal Reserve Board of Governors)
    Abstract: Firms with limited internal liquidity significantly increased prices in 2008, while their liquidity unconstrained counterparts slashed prices. Differences in the firms' price-setting behavior were concentrated in sectors likely characterized by customer markets. The authors develop a model in which firms face financial frictions while setting prices in a customer-markets setting. Financial distortions create an incentive for firms to raise prices in response to adverse demand or financial shocks. These results reflect the firms' reaction to preserve internal liquidity and avoid accessing external finance, factors that strengthen the countercyclical behavior of markups and attenuate the response of inflation to fluctuations in output.
    Keywords: missing deflation; sticky customer base; costly external finance; financial shocks; cost channel; inflation-output tradeoff
    JEL: E31 E32 E44 E51
    Date: 2015–11–01
  8. By: Jill Vardy
    Abstract: This paper discusses reputational risk in the context of central banking and explains why it matters to central banks. It begins with a general discussion of reputational risk within the broader framework of risk management. It then outlines how central banks define, measure, monitor and manage reputational risk, citing examples from central banks around the world, including the Bank of Canada. Finally, it presents a model for integrating reputational risk into policy analysis and operational planning—an “embedded communications” approach that ensures such considerations are brought into the core of central bank decision making.
    Keywords: Credibility, International topics, Monetary policy implementation
    JEL: E5 E52 E58
    Date: 2015
  9. By: Papafilis, Michalis-Panayiotis; Psillaki, Maria; Margaritis, Dimitris
    Abstract: This paper examines the changes in the interdependence between sovereign and bank credit risk, that were noticed, after the announcement of the voluntary exchange program of Greek bonds, with the participation of the private sector (Private Sector Involvement - PSI). More precisely, we investigate the progress of the credit default swaps (CDS) of eight eurozone countries and of twenty-one banking institutions, for the period of January 2009 to May 2014. We divide the sample into two sub-periods, based on the announcement of the program. We apply Hsiao's methodology (1981), in order to ascertain the causality which is observed between the CDS series and potential changes in their relationship, due to the implementation of the PSI. We identify limited causality relations between countries and banks of the sample examined, in the second sub-period, while the size of the interaction is reduced in the same period. After developing a Difference-in-Difference model, we confirm the weakening of causal relationships between the CDS series studied, for the period, after the announcement of the PSI. Our results suggest that the implementation of the PSI has contributed to the limitation of the interdependence between the CDS spreads of the sovereigns and banks in the period that follows.
    Keywords: CDS spreads, PSI, sovereign credit risk, bank credit risk, debt crisis, contagion, eurozone
    JEL: F34 F42 G28 H12 H63
    Date: 2015–11–24
  10. By: Phelan, Christopher (Federal Reserve Bank of Minneapolis)
    Abstract: Banks in the United States have the potential to increase liquidity suddenly and significantly—from $12 trillion to $36 trillion in currency and easily accessed deposits—and could thereby cause sudden inflation. This is possible because the nation’s fractional banking system allows banks to convert excess reserves held at the Federal Reserve into bank loans at about a 10-to-1 ratio. Banks might engage in such conversion if they believe other banks are about to do so, in a manner similar to a bank run that generates a self-fulfilling prophecy. {{p}} Policymakers could guard against this inflationary possibility by the Fed selling financial assets it acquired during quantitative easing or by Congress significantly raising reserve requirements.
    Date: 2015–11–03
  11. By: Marie Brière; Valérie Mignon; Kim Oosterlinck; Ariane Szafarz
    Abstract: This paper compares the performance of various diversification strategies regarding foreign exchange reserves. The aim is to provide central banks with guidelines in portfolio allocation. We pay particular attention to the situation of upward pressures on U.S. interest rates by implementing our analysis over both the whole 1986-2015 period and a rising rate subsample. Relying on geometric tests of mean-variance efficiency, we show that introducing currencies weakly correlated to the USD (AUD and CAD) significantly reduces portfolio risk. Expected return is improved through mortgage-backed securities, corporate bonds, and equities.
    Keywords: Foreign exchange reserves; diversification; asset allocation.
    JEL: F31 G11 G15 E58
    Date: 2015
  12. By: Butt, Nick (Bank of England); Churm, Rohan (Bank of England); McMahon, Michael (University of Warwick, CEPR, CAGE (Warwick), CfM (LSE), and CAMA (ANU)); Morotz, Arpad (Bank of England); Schanz, Jochen (Bank for International Settlements)
    Abstract: We test whether quantitative easing (QE), in addition to boosting aggregate demand and inflation via portfolio rebalancing channels, operated through a bank lending channel (BLC) in the UK. Using Bank of England data together with an instrumental variables approach, we find no evidence of a traditional BLC associated with QE. We show, in a simple framework, that the traditional BLC is diminished if the bank receives `flighty' deposits (deposits that are likely to quickly leave the bank). We show that QE gave rise to such flighty deposits which may explain why we find no evidence of a BLC.
    Keywords: Monetary policy; Bank lending channel; Quantitative Easing JEL Classification: E51, E52, G20
    Date: 2015
  13. By: Alexander Kriwoluzky; G. J. Müller; M. Wolf
    Abstract: Membership in a currency union is not irreversible. Exit expectations may emerge during sovereign debt crises, because exit allows countries to reduce their liabilities through a currency redenomination. As market participants anticipate this possibility, sovereign debt crises intensify. We establish this formally within a small open economy model of changing policy regimes. The model permits explosive dynamics of debt and sovereign yields inside currency unions and allows us to distinguish between exit expectations and those of an outright default. By estimating the model on Greek data, we quantify the contribution of exit expectations to the crisis dynamics during 2009 to 2012.
    Keywords: currency union, exit, sovereign debt crisis, fiscal policy, redenomination premium, euro crisis, regime-switching model
    JEL: E52 E62 F41
    Date: 2015–11
  14. By: Ackon, Kwabena
    Abstract: The relationship between money and macroeconomic variables such as output, inflation and unemployment is the basis of macroeconomic policy piquing the interests of both academic economists and policy makers especially in the aftermath of the Great Recession. With the Federal Reserve expanding its balance sheet by an estimated $4 trillion, the current economic debate is whether there is a stable relationship between money and macroeconomic variables. In fact, previous research had shown that the link is tenuous and a more recent paper by Aksoy and Piskorski (2006) had concluded that accounting for the foreign holdings of US dollars holds predictive content for the path key macroeconomic variables such as output and inflation. This paper aimed to test this theory on a larger dataset including testing a small sample for the period after the Great Recession. I found that accounting for foreign holdings of US dollars improved the intrinsic information held in domestic money for the path of output after the great recession and the path of inflation between 1965-2007.
    Keywords: Currency, Money, Output, Inflation, Unemployment, Granger Causality, Forecasting
    JEL: E0 E3 E31 E37 E5 E52 E58
    Date: 2015–11–27
  15. By: Marcelo Brutti Righi
    Abstract: In this paper we present a class of risk measures composed of coherent risk measures with generalized deviation measures. Based on the Limitedness axiom, we prove that this set is a sub-class of coherent risk measures. We present extensions of this result for the case of convex or co-monotone coherent risk measures. Under this perspective, we propose a specific formulation that generates, from any coherent measure, a generalized deviation based on the dispersion of results worse than it, which leads to a very interesting risk measure. Moreover, we present some examples of risk measures that lie in our proposed class.
    Date: 2015–11
  16. By: D’Aguanno, Lucio (Department of Economics University of Warwick)
    Abstract: What are the welfare gains from being in a currency union? I explore this question in the context of a dynamic stochastic general equilibrium model with monetary barriers to trade, local currency pricing and incomplete markets. The model generates a trade off between monetary independence and monetary union. On one hand, distinct national monetary authorities with separate currencies can address business cycles in a countryspecific way, which is not possible for a single central bank. On the other hand, short-run violations of the law of one price and long-run losses of international trade occur if different currencies are adopted, due to the inertia of prices in local currencies and to the presence of trade frictions. I quantify the welfare gap between these two international monetary arrangements in consumption equivalents over the lifetime of households, and decompose it into the contributions of di.erent frictions. I show that the welfare ordering of alternative currency systems depends crucially on the international correlation of macroeconomic shocks and on the strength of the monetary barriers affecting trade with separate currencies. I estimate the model on data from Italy, France, Germany and Spain using standard Bayesian tools, and I find that the trade off is resolved in favour of a currency union among these countries.
    Keywords: Currency union ; Incomplete markets ; Nominal rigidities ; Local currency pricing ; Trade frictions ; Welfare
    JEL: D52 E31 E32 E42 E52 F41 F44
    Date: 2015
  17. By: Asonuma, Tamon; Trebesch, Christoph
    Abstract: Sovereign debt restructurings can be implemented preemptively - prior to a payment default. We code a comprehensive new dataset and find that preemptive restructurings (i) are frequent (38% of all deals 1978-2010), (ii) have lower haircuts, (iii) are quicker to negotiate, and (iv) see lower output losses. To rationalize these stylized facts, we build a quantitative sovereign debt model that incorporates preemptive and post-default renegotiations. The model improves the fit with the data and explains the sovereign's optimal choice: preemptive restructurings occur when default risk is high ex-ante, while defaults occur after unexpected bad shocks. Empirical evidence supports these predictions.
    Keywords: crisis resolution; debt restructuring; default; sovereign debt
    JEL: F34 F41 H63
    Date: 2015–11

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