nep-cba New Economics Papers
on Central Banking
Issue of 2019‒10‒14
thirty-two papers chosen by
Sergey E. Pekarski
Higher School of Economics

  1. Cash is King - Effects of ECB's Conventional and Unconventional Measures By Martin Baumgaertner; Jens Klose
  2. Monetary Policy and the Limits to Arbitrage: Insights from a New Keynesian Preferred Habitat Model By Walker Ray
  3. Asset Price Beliefs and Optimal Monetary Policy By Colin Caines; Fabian Winkler
  4. Inside Money, Investment, and Unconventional Monetary Policy By Lukas Altermatt
  5. Monetary policy for commodity booms and busts By Drechsel, Thomas; McLeay, Michael; Tenreyro, Silvana
  6. Fiscal distress and banking performance: The role of macroprudential regulation By Balfoussia, Hiona; Dellas, Harris; Papageorgiou, Dimitris
  7. Stock Market's Assessment of Monetary Policy Transmission: The Cash Flow Effect By Gürkaynak, Refet S.; Karasoy Can, Gokce; Lee, Sang Seok
  8. Bank intermediation activity in a low interest rate environment By Borio, Claudio; Brei, Michael; Gambacorta, Leonardo
  9. Monetary Policy in Sudden Stop-prone Economies By Louphou Coulibaly
  10. To democratize finance, democratize central banking By Woodruff, David M.
  11. "Inflation Target and Anchor of Inflation Forecasts in Japan" By Shin-ichi Fukuda; Naoto Soma
  12. Supervisory Governance, Capture and Non-Performing Loans By Niccolò Fraccaroli
  13. The Interaction Between ConventionalMonetary Policy and Financial Stability: Chile, Colombia, Japan, Portugal and the UK By Zoe Venter
  14. Business Liquidity, Consumer Liquidity, and Monetary Policy By Chao He; Min Zhang
  15. Micro Jumps, Macro Humps: monetary policy and business cycles in an estimated HANK model By Adrien Auclert; Ludwig Straub; Matthew Rognlie
  16. The Long-term Rate and Interest Rate Volatility in Monetary Policy Transmission By Chen, Zhengyang
  17. The Dollar During the Great Recession: US Monetary Policy Signaling and The Flight To Safety By Stavrakeva, Vania; Tang, Jenny
  18. Global Effective Lower Bound and Unconventional Monetary Policy By Jing Cynthia Wu; Ji Zhang
  19. Stable Money and Central Bank Independence: Implementing Monetary Institutions in Postwar Germany By Carsten Hefeker
  20. Negative interest rates in the euro area: does it hurt banks? By Jan Stráský; Hyunjeong Hwang
  21. Deposit Spreads and the Welfare Cost of Inflation By Pablo Kurlat
  22. Firm Debt Covenants and the Macroeconomy: The Interest Coverage Channel By Daniel Greenwald
  23. The reaction function channel of monetary policy and the financial cycle By Andrew Filardo; Paul Hubert; Phurichai Rungcharoenkitkul
  24. A New Keynesian DSGE model for Low Income Economies with Foreign Exchange Constraints By Bertha C. Bangara
  25. Public Debt and the Slope of the Term Structure By Thien Nguyen
  26. Emergency Liquidity Injections By Nicholas Garvin
  27. A Monetary-Fiscal Theory of the Price Level By David Miller
  28. Preferred Habitat, Policy, and the CIP Puzzle By Paul Wohlfarth
  29. What Happens if Central Banks Misdiagnose a Slowdown in Potential Output By Bas B. Bakker
  30. Financial Repression is Knocking at the Door, Again By Etibar Jafarov; Rodolfo Maino; Marco Pani
  31. The Political Economy of a Diverse Monetary Union By Perotti, Enrico C; Soons, Oscar
  32. Means of Payment By Nancy L Stokey

  1. By: Martin Baumgaertner (THM Business School); Jens Klose (THM Business School)
    Abstract: In this paper we distinguish the responses of conventional and unconventional monetary policy measures on macroeconomic variables, using a high frequency data set which measures the impact of the ECB's monetary policy decisions. For the period 2002:01 to 2019:06 we show that unconventional and conventional monetary policy measures dffer considerably with respect to inflation. While conventional measures show the expected response, i.e. an interest rate cut increases inflation and vice versa, unconventional measure appear to have no signicant influence. But this holds not for QE, which is found to have similar influence on inflation as conventional interest rate changes.
    Keywords: Unconventional Monetary Policy, High-Frequency Data, ECB
    JEL: E52 E58 C36
    Date: 2019
  2. By: Walker Ray (UC Berkeley)
    Abstract: With conventional monetary policy unable to stabilize the economy in the wake of the global financial crisis, central banks turned to unconventional tools. This paper embeds a model of the term structure of interest rates featuring market segmentation and limits to arbitrage within a New Keynesian model to study these policies. Because the transmission of monetary policy depends on private agents with limited risk-bearing capacity, financial market disruptions reduce the efficacy of both conventional policy as well as forward guidance. Conversely, financial crises are precisely when large scale asset purchases are most effective. Policymakers can take advantage of the inability of financial markets to fully absorb these purchases, which can push down long-term interest rates and help stabilize output and inflation.
    Date: 2019
  3. By: Colin Caines (Federal Reserve Board); Fabian Winkler (Federal Reserve Board)
    Abstract: We characterize optimal monetary policy when agents have extrapolative beliefs about asset prices. Such boundedly rational expectations induce inefficient asset price and aggregate demand fluctuations. We find that the optimal monetary policy raises interest rates when expected capital gains or the level of current asset prices is high, but does not eliminate deviations of asset prices from their fundamental value. When the asset is in elastic supply, optimal policy also leans against the wind, tolerating low inflation and output when asset prices are too high. Optimal policy can be reasonably approximated by simple interest rate rules that respond to capital gains. Our results are robust to a wide range of belief specifications.
    Date: 2019
  4. By: Lukas Altermatt (University of Wisconsin-Madison)
    Abstract: I develop a new monetarist model to analyze why an economy can fall into a liquidity trap, and what the effects of unconventional monetary policy measures such as helicopter money and negative interest rates are under these circumstances. I find that liquidity traps can be caused by a decrease in the bonds-to-money ratio, by a decrease in productivity of capital, or by an increase in demand for consumption. The model shows that, while conventional monetary policy cannot control inflation in a liquidity trap, unconventional monetary policies allow the monetary authority to regain control over the inflation rate, and that an increase in the bonds-to-money ratio is the only welfare-improving policy.
    Date: 2019
  5. By: Drechsel, Thomas; McLeay, Michael; Tenreyro, Silvana
    Abstract: Macroeconomic volatility in commodity-exporting economies is closely tied to fluctuations in international commodity prices. Commodity booms improve exporters' terms of trade and loosen their borrowing conditions, while busts lead to the reverse. This paper studies optimal monetary policy for commodity exporters in a small open economy framework that includes a key role for financial conditions. We incorporate the interaction between the commodity and financial cycles via a working capital constraint for commodity producers, which loosens as commodity prices increase. A rise in global commodity prices causes an inefficient reallocation towards the commodity sector, which expands and increases its demand for inputs. The real exchange-rate appreciates, but because domestic fims do not internalize that the appreciation reduces the scale of the reallocation, they do not raise prices enough. An inefficient boom takes place, with inflation rising and output increasing relative to its welfare-maximizing level. Returning inflation to target is not sufficient to close the output gap, leaving the policymaker facing a stabilization tradeoff. The optimal policy lets the exchange rate appreciate and raises interest rates, with a larger rate rise required the greater the loosening in borrowing conditions. The paper compares alternative policy rules and discusses a key practical challenge for emerging and developing economies: how to transition to a stable path from initial conditions of high and persistent inflation.
    Keywords: Commodity financialization; commodity prices; Exchange Rates; monetary policy; small open economy
    JEL: E31 E52 E58 F41 Q02 Q30
    Date: 2019–09
  6. By: Balfoussia, Hiona; Dellas, Harris; Papageorgiou, Dimitris
    Abstract: Fiscal fragility can undermine a government's ability to honor its bank deposit insurance pledge and induces a positive correlation between sovereign default risk and financial (bank) default risk. We show that this positive relation is reversed if bank capital requirements in fiscally weak countries are allowed to adjust optimally. The resulting higher requirements buttress the banking system and support higher output and welfare relative to the case where macroprudential policy does not vary with the degree of fiscal stress. Fiscal tenuousness also exacerbates the effects of other risk shocks. Nonetheless, the economy's response can be mitigated if macroprudential policy is adjusted optimally. Our analysis implies that, on the basis of fiscal strength, fiscally weak countries would favor and fiscally strong countries would object to banking union.
    Keywords: bank performance; Banking Union; Fiscal distress; Greece; optimal macroprudential policy
    JEL: E3 E44 G01 G21 O52
    Date: 2019–09
  7. By: Gürkaynak, Refet S.; Karasoy Can, Gokce; Lee, Sang Seok
    Abstract: We show that firm liability structure and associated cash flow matter for firm behavior, and that financial market participants price stocks accordingly. Looking at firm level stock price changes around monetary policy announcements, we find that firms that have more cash flow exposure see their stock prices affected more. The stock price reaction depends on the maturity and type of debt issued by the firm, and the forward guidance provided by the Fed. This effect has remained intact during the ZLB period. Importantly, we show that the effect is not a rule of thumb behavior outcome and that the marginal stock market participant actually studies and reacts to the liability structure of firm balance sheets. The cash flow exposure at the time of monetary policy actions predicts future net worth, investment, and assets, verifying the stock pricing decision and also providing evidence of cash flow effects on firms' real behavior. The results hold for S&P500 firms that are usually thought of not being subject to tight financial constraints.
    Keywords: Cash flow effect of monetary policy; Financial Frictions; Investor sophistication; stock pricing
    JEL: E43 E44 E52 E58 G14
    Date: 2019–09
  8. By: Borio, Claudio; Brei, Michael; Gambacorta, Leonardo
    Abstract: This paper investigates how the prolonged period of low interest rates affects bank intermediation activity. We use data for 113 large international banks headquartered in 14 major advanced economies during the period 1994â??2015. We find that low interest rates induce banks to shift their activities from interest-generating to fee-related and trading activities. This rebalancing is stronger for low capitalised banks. Banks also moderately adjust their funding structure, away from short-term market funding towards deposits. We observe a concomitant decline in the risk-weighted asset ratio and a reduction in loan-loss provisions, which is consistent with signs of evergreening.
    Keywords: bank business models; financial crisis; monetary policy
    JEL: C53 E43 E52 G21
    Date: 2019–09
  9. By: Louphou Coulibaly (University of Montreal)
    Abstract: Monetary policy procyclicality is a pervasive feature of emerging market economies. In this paper, I propose a parsimonious theory explaining this fact in a model where access to foreign financing depends on the real exchange rate and the government lacks commitment. The discretionary monetary policy is procyclical to mitigate balance sheet effects originating from exchange rate depreciations during sudden stops. Committing to an inflation targeting regime is found to increase social welfare and reduce the frequency of financial crises, despite increasing their severity. Finally, the ability to use capital controls induces a less procyclical discretionary monetary policy and delivers higher welfare gains than an inflation targeting regime by reducing both the frequency and the severity of crises.
    Date: 2019
  10. By: Woodruff, David M.
    Abstract: Hockett’s “franchise view” argues, convincingly, that the capacity of banks or quasi-bank financial entities to create money rests on the regulations and guarantees of the state maintaining the legal and regulatory system under which they operate. Block suggests that this insight could be used as a beachhead from which to establish the legitimacy of locally embedded, non-profit lenders whose investments would be dedicated to public purposes. However, given the contemporary ideological, political, and economic context, this proposal on its own could prove counterproductive. To maximize the positive impact of the insight into the public character of money creation, the proposal for public-purpose banking should be fused to democratization of central banking. This could plausibly have ideological effects that would make the public character of private economic power easier to perceive, and to reshape. Subordination of central banks to elected officials would also bring an end to the dynamic whereby monetary easing provides political cover for damaging fiscal austerity, leading to more democratic decision-making about the appropriate combination of fiscal and monetary policy.
    Keywords: Central bank independence; everyday libertarianism; coordination of fiscal and monetary policy
    JEL: F3 G3
    Date: 2019–06–19
  11. By: Shin-ichi Fukuda (Faculty of Economics, The University of Tokyo); Naoto Soma (Faculty of Economics, The University of Tokyo)
    Abstract: In literature, a number of studies argued that an explicit inflation targeting regime provides less uncertainty about future inflation rates through anchoring expectations. However, it is far from clear whether the argument still holds true when the central bank faces a serious difficulty in achieving the target. The Bank of Japan (BOJ) is a central bank that has adopted an explicit inflation target but faced a serious difficulty in achieving it. The purpose of this paper is to explore whether the explicit inflation targeting regime could anchor inflation expectations in Japan. In the analysis, we estimate panel Phillips curves by using Japanese forecaster-level data of “ESP Forecast†. We find significant structural changes in how to form inflation expectations. Before the BOJ announced the 2% inflation target, the estimated anchor of inflation expectations was negative. The new target increased the estimated anchor to significant positive values. This suggests that the BOJ’s explicit inflation target could partly anchor inflation expectations. However, the estimated anchor has never reached the target. More importantly it started to decline when it turned out that the 2% target would not be feasible in the short-run. This implies that an explicit inflation targeting needs to be a feasible one to anchor inflation expectations persistently.
    Date: 2019–01
  12. By: Niccolò Fraccaroli (DEF University of Rome "Tor Vergata")
    Abstract: Supervisory governance is believed to affect financial stability. While the literature has identified pros and cons of having a central bank or a separate agency responsible for microprudential banking supervision, the advantages of having this task shared by both institutions have received considerably less attention in the literature. Shared supervision has however inherent benefits for the stability of the banking system, as it increases the costs of supervisory capture: capturing a single supervisor, be it the central bank or an agency, has in fact lower costs than capturing two. Nevertheless, while this argument has been proposed theoretically, it has never been tested empirically. This paper fills this void introducing a new dataset on the supervisory governance of 116 countries from 1970 to 2016. It finds that, while nonperforming loans are not significantly affected by supervisory governance per se, they are significantly lower in countries where supervision is shared and the risk of capture is high. This last result, which is robust to a number of controls and robustness checks, proves new evidence in support of the detrimental impact of shared supervision on supervisory capture.
    Keywords: banking supervision, supervisory capture, NPLs
    JEL: G18 G38 E58 P16 D73
    Date: 2019–10–08
  13. By: Zoe Venter
    Abstract: The relationship between monetary policy and financial stability has gained importance in recent years as Central Bank policy rates neared the zero-lower bound. The need to coordinate policy choices, to expand the scope of monetary policy measures and lastly, the need to target financial stability objectives while maintaining a primary objective of financial stability, has become essential. We use an SVAR model and impulse response functions to study the impact of monetary policy shocks on three proxiesforfinancial stabilityas well as a proxy for economic growth. Our main results show that the Central Bank policy rate may be used to correct asset mispricing due to the inverse relationship between the policy rate and the stock market index. The results also show that, in line with theory,the exchange rate appreciates following a positive interest rate shock. Although the impact is only statistically significant for industrial production for the case of the UK, conventional monetary policy may indeed be able to contribute to financial stability when used in conjunction with alternative policy choices.
    Keywords: Monetary Policy, Financial Stability, Structural Vector Autoregressive Model
    JEL: E52 F42 F34 F55
    Date: 2019–09
  14. By: Chao He (East China Normal University); Min Zhang (East China Normal University)
    Abstract: Existing studies of liquidity either focus on firms or consumers. However, both hold significant cash, and firms' share increased since the '90s and fell after the 07-08 financial crisis. We propose a theory of how endogenous investment liquidity and consumption liquidity compete and interact. The consumption-investment liquidity allocation (CILA) channel amplifies the effect of monetary policy on unemployment, as it accounts for 40 percent of the effect in the calibrated model. We also show that a lower nominal interest rate directs relatively more cash to firms, whereas financial frictions induce the opposite and high unemployment, consistent with the observed patterns.
    Date: 2019
  15. By: Adrien Auclert (Stanford); Ludwig Straub (Harvard); Matthew Rognlie (Northwestern University)
    Abstract: We estimate a Heterogeneous-Agent New Keynesian model that matches existing microeconomic evidence on marginal propensities to consume and macroeconomic ev- idence on the impulse response to a monetary policy shock. We rule out habit forma- tion as an explanation for the hump shape of output, but show that sticky information in the sense of Mankiw and Reis (2002) can rationalize both the micro and the macro data. Our estimated model implies a central role for investment in the monetary transmission mechanism.
    Date: 2019
  16. By: Chen, Zhengyang
    Abstract: The federal funds rate became uninformative about the stance of monetary policy from December 2008 to November 2015. During the same period, unconventional monetary policy actions, like large-scale asset purchases, show the Federal Reserve’s intention to depress longer-term interest rates. This paper considers a long-term real interest rate as an alternative monetary policy indicator in a structural VAR framework. Based on an event study of FOMC announcements, I advance a novel measure of long-term interest rate volatility with important implication for monetary policy identification. I find that monetary policy shocks identified with this volatility measure drive significant swings in credit market sentiments and real output. In contrast, monetary policy shocks identified by otherwise standard unexpected policy rate changes lead to muted responses of financial frictions and production. Our results support the validity of the risk-taking channel and suggest an indispensable role of financial markets in monetary policy transmission.
    Keywords: Monetary policy transmission; Risk-taking channel; Structural vector autoregression; High-frequency identification
    JEL: E3 E4 E5 G0
    Date: 2019–09–30
  17. By: Stavrakeva, Vania; Tang, Jenny
    Abstract: Conventional wisdom holds that lowering a home country's interest rate relative to another's will depreciate the domestic currency. We document that US monetary policy easings actually had the opposite effect during the Great Recession. We attribute this effect to calendar-based forward guidance that signaled economic weakness which resulted in a flight-to-safety effect and lower expected inflation in the United States. Our results imply that accusations that the Federal Reserve engaged in a "competitive devaluation" over the Great Recession were unfounded.
    JEL: E52 F31 G01
    Date: 2019–10
  18. By: Jing Cynthia Wu (University of Notre Dame); Ji Zhang (PBC School of Finance, Tsinghua University)
    Abstract: In a standard open-economy New Keynesian model, the effective lower bound causes anomalies: output and terms of trade respond to a supply shock in the opposite direction compared to normal times. We introduce a tractable framework to accommodate for unconventional monetary policy. In our model, these anomalies disappear. We allow unconventional policy to be partially active and asymmetric between countries. Empirically, we nd the US, Euro area, and UK have implemented a considerable amount of unconventional monetary policy: the US follows the historical Taylor rule, whereas the others have done less compared to normal times.
    Date: 2019
  19. By: Carsten Hefeker (University of Siegen)
    Abstract: Germany prides itself in having one of the most successful central banks and currencies with respect to independence and stability. I show that not only were both imposed on the country after 1945 but that there was also initial resistance to both among German experts and officials. This was then a rare case of successful imposition of institutions from abroad. Events are discussed in light of Peter Bernholz’s requirements for stable money and a successful central bank.
    Keywords: Currency reform, Bundesbank, central bank independence, institutional reform
    JEL: E42 E58 N14 N24
    Date: 2019
  20. By: Jan Stráský; Hyunjeong Hwang
    Abstract: The negative interest rate policy (NIRP) has been in place in the euro area since June 2014. While the NIRP can provide additional monetary accommodation in the situation where the neutral rate of interest is most likely negative, there are also unintended consequences for banks’ profitability and potential financial stability risks associated with this policy. The paper assesses the effect of the NIRP on the net interest rate margins of the euro area banks using quarterly consolidated bank level data for some 50 banking groups directly supervised by the Single Supervisory Mechanism. Since our data set extends to 2018, it allows us to examine the period of negative short-term interest rates separately from the period of low, but positive policy rates. The econometric results confirm the effect of the interest rate level on bank profitability and, in some specifications, also suggest an additional negative effect on bank profitability in the period of negative euro area short-term interest rates. This additional effect of the NIRP is the strongest when looking at the disaggregated components of net interest income, i.e. interest income and interest expense. However, the effects are not particularly robust across various profitability measures and tend to disappear when conditioning on macroeconomic variables, such as expected real GDP growth and inflation expectations. Therefore, in line with other existing studies, we find weak evidence of possible negative effects on bank profitability from keeping rates low for an extended period of time. Statistical analysis of the bank-level data also points to an ongoing compression of non-interest income, in particular for the best performing banks, and a slow recovery in return on total assets among all banks over the analysed period.This Working Paper relates to the 2018 OECD Economic Survey of Euro Area( rea-and-european-union-economic-snapshot /)
    Keywords: bank profitability, lower bound, monetary policy, negative rates
    JEL: E43 E52 E58 G21 G28
    Date: 2019–10–14
  21. By: Pablo Kurlat (Stanford)
    Abstract: Since bank deposits and currency are substitutes and banks have monopoly power, higher nominal interest rates lead to higher deposit spreads. This raises the cost of transaction services, increases bank profits and attracts entry into the banking sector. Taking these effects into account, a one percentage point increase in inflation has a welfare cost of 0.086% of GDP, 6.9 times higher than traditional estimates.
    Date: 2019
  22. By: Daniel Greenwald (MIT)
    Abstract: Interest Coverage covenants, which set a maximum ratio of interest payments to earnings, are among the most popular provisions in firm debt contracts. For affected firms, the amount of additional debt that can be issued without violating these covenants is highly sensitive to interest rates. Combining a theoretical model with firm-level data, I find that Interest Coverage limits generate strong amplification from interest rates into firm borrowing and investment. Importantly, most firms that have Interest Coverage covenants also face a maximum on the ratio of the stock of debt to earnings. Simultaneously imposing these limits implies a novel source of state-dependence: when interest rates are high, interest coverage limits are tighter, amplifying the influence of interest rate changes and monetary policy. Conversely, in low-rate environments, debt-to-earnings covenants dominate and transmission is weakened.
    Date: 2019
  23. By: Andrew Filardo (Bank for International Settlements (BIS)); Paul Hubert (Observatoire français des conjonctures économiques); Phurichai Rungcharoenkitkul (Bank for International Settlements (BIS))
    Abstract: This paper examines whether monetary policy reaction function matters for financial stability. We measure how responsive the Federal Reserve’s policy appears to be to imbalances in the equity, housing and credit markets. We find that changes in these policy sensitivities predict the later development of financial imbalances. When monetary policy appears to respond more countercyclically to market overheating, imbalances tend to decline over time. This effect is distinct from that of current and anticipated interest rate levels – the risk-taking channel. The evidence highlights the importance of a “policy reaction function” channel of monetary policy in shaping the financial cycle.
    Keywords: Policy reaction function channel; Asset price booms; Credit booms; Monetary policy; Financial cycles; Time varying models
    JEL: E50 E52 G00 G12
    Date: 2019–10
  24. By: Bertha C. Bangara
    Abstract: The existing literature is clear that low income economies tend to suffer from foreign exchange shortages exacerbated by their exports. Most importantly, the concentration of their exports renders these countries susceptible to international price fluctuations. This frequently affects the level of foreign exchange, causing excess demand for foreign exchange leading to foreign exchange shortages. Using a four-sector New Keynesian dynamic stochastic general equilibrium (DSGE) model with foreign exchange constraints faced by importing rms, we calibrate the model to Malawian economy to investigate the implications of foreign exchange constraints on key macroeconomic variables in low income import dependent economies. We demonstrate that imports are a vital part of the production process for LIEs and determine the response and direction of output and consumption. Second, the degree of the foreign exchange constraint determines the degree of variability of the shock, but, does not change the direction of the shock. Third, increasing imports in an effort to increase productivity reduces output and consumption and induces a depreciation of the exchange rate. Fourth, the model illustrates that the domestic contractionary monetary policy produces the conventional results on output, consumption and other variables.
    Keywords: Low income economies, Foreign Exchange Constraints, DSGE, Malawi
    JEL: E32 F31 F35 O55
    Date: 2019–09
  25. By: Thien Nguyen (Ohio State University)
    Abstract: This paper documents that the public debt-to-GDP ratio predicts negatively one- to five-year cumulative nominal consumption growth. Moreover, a higher debt-to-GDP ratio is associated with higher yield spreads, controlling for output gap and inflation. I examine these facts in a New Keynesian DSGE model in which growth and inflation are endogenous. In this model, high government debt forecasts low growth and deflation, making bonds attractive assets in high debt states. Furthermore, due to mean-reversions of fundamental processes that drive the economy, longer-term bonds are better hedges than shorter-term ones, resulting in increases in the slope of the term structure at times of high public debt and hence the empirical regularities seen in the data. My paper thus furthers our understanding of what determine bond yields and the impact of quantitative easing.
    Date: 2019
  26. By: Nicholas Garvin (Reserve Bank of Australia)
    Abstract: This paper compares the effectiveness of different forms of emergency liquidity injections, including secured lending (repo), unsecured lending and securities purchases. The model features an endogenous banking crisis, funding and market liquidity interactions, and fire sale externalities. Injection policies are compared by their effects on ex ante incentives and on ex post outcomes. The model demonstrates that lending to banks via repo can curb fire selling of relatively illiquid securities that are accepted as collateral, due to binding collateral constraints. The mitigated securities price depression, relative to an unsecured lending policy, counteracts the effects of fire sale externalities. This reduces banks' losses on illiquid securities without incentivising more liquidity risk-taking. Under an unsecured or secured lending policy, the authority can charge 'penalty rates' to deter liquidity risk-taking, but to be credible, lending should be long term so that repayments are due after liquidity conditions improve. Otherwise, the repayments can cause further liquidity distress, compromising the policy objectives. Liquidity injections via securities purchases cannot credibly be penalising, because the policy does not require banks to commit future income.
    Keywords: banking crisis; bailout; repo; collateral; market liquidity; funding liquidity
    JEL: G01 G12 G21 E52 E58
    Date: 2019–10
  27. By: David Miller (Federal Reserve Board)
    Abstract: Treating nominal government bonds as safe assets leads to a new theory of the price level. Holmstrom (2015) and Gorton (2017) define safe assets as having opaque backing with costly-to-forecast returns. I confirm this definition's empirical implications for government bonds, and analyze the theoretical implications. Government bonds' nominal return is their face value, however their real return is determined by the government's surplus. While consumers hold uninformed beliefs about the surplus, the monetary authority exerts control of the price level. In troubled times, the fiscal authority exerts control as consumers worry about default and pay a high cost to accurately forecast the surplus.
    Date: 2019
  28. By: Paul Wohlfarth (Birkbeck, University of London)
    Abstract: A crucial no-arbitrage condition on foreign exchange markets, covered interest parity (CIP),held almost exactly before the Global Financial Crisis (GFC) and failed since then. CIP deviations have been particularly puzzling in relatively calm markets after 2014. This paper explains deviations from CIP, measured by the cross-currency basis from swaps (CCBS), in terms of significant policy and volatility effects in a preferred habitat model of the Eurodollar swap market. Estimation is done using EGARCH in mean for a set of CCBS maturities. The term structure of the CCBS is further analysied in a Vector Error Correction Model(VECM).
    Keywords: Macro Finance, International Monetary Economics, Preferred Habitat, Foreign Exchange Markets, International Finance
    JEL: E43 E44 E5 F31 G12 G15
    Date: 2019–10
  29. By: Bas B. Bakker
    Abstract: In the last few decades, real GDP growth and investment in advanced countries have declined in tandem. This slowdown was not the result of weak demand (there has been no shift along the Okun curve), but of a decline in potential output growth (which has shifted the Okun curve to the left). We analyze what happens if central banks mistakenly diagnose the problem as insufficient demand, when it is actually a supply problem. We do this in a real model, in which inflation is not an issue. We show that aggressive central bank action may revive gross investment, but it will not revive net investment or growth. Moreover, low interest rates will lead to an increase in the capital output ratio, a low return on capital and high leverage. We show that these forecasts are in line with what has happened in major advanced countries.
    Date: 2019–09–27
  30. By: Etibar Jafarov; Rodolfo Maino; Marco Pani
    Abstract: Financial repression (legal restrictions on interest rates, credit allocation, capital movements, and other financial operations) was widely used in the past but was largely abandoned in the liberalization wave of the 1990s, as widespread support for interventionist policies gave way to a renewed conception of government as an impartial referee. Financial repression has come back on the agenda with the surge in public debt in the wake of the Global Financial Crisis, and some countries have reintroduced administrative ceilings on interest rates. By distorting market incentives and signals, financial repression induces losses from inefficiency and rent-seeking that are not easily quantified. This study attempts to assess some of these losses by estimating the impact of financial repression on growth using an updated index of interest rate controls covering 90 countries over 45 years. The results suggest that financial repression poses a significant drag on growth, which could amount to 0.4-0.7 percentage points.
    Date: 2019–09–30
  31. By: Perotti, Enrico C; Soons, Oscar
    Abstract: We analyze the political economy of monetary unification among countries with different quality of institutions. Countries with stronger institutions have lower public spending and better investment incentives, even under a stronger currency. Governments under weaker institutions spend more so must occasionally devalue. In a MU market prices and flows adjust quickly but institutional differences persist, so a diverse monetary union (DMU) has many redistributive effects. The government in the weaker country expand spending and investment may be reduced by the fiscal and common exchange rate effect. Strong country production benefits from the weaker currency but needs to offer fiscal support in a fiscal crisis, a transfer legitimized by its ex ante devaluation gain. Some governments may join a DMU even if it depresses productive capacity to expand public spending. Even in a DMU beneficial for all countries, workers and firms in weaker countries and savers in stronger countries may lose.
    Keywords: institutional quality; institutions; Monetary Unions; political economy
    Date: 2019–09
  32. By: Nancy L Stokey (Department of Economics)
    Abstract: When consumers or firms purchase goods or pay bills, they must choose a means of payment: cash, credit card, check, electronic transfer, etc. What governs those choices? In particular, how do their choices vary with the inflation rate, and how do total transaction costs change?
    Date: 2019

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