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Introduction The model Interpretation The central-bank balance sheet as an instrument of monetary policy V. Cúrdia and M. Woodford Lecture 2 Jonathan Benchimol1 This presentation does not necessarily re‡ect the views of the Bank of Israel February 2016 1 Bank of Israel and EABCN Jonathan Benchimol Bank of Israel Introduction The model Interpretation Research questions Findings Literature review I Cúrdia and Woodford (2009). Credit frictions and optimal monetary policy, BIS Working Papers 278. I Cúrdia and Woodford (2010c). Credit spreads and monetary policy. Journal of Money, Credit and Banking 42(s1), 3–35. I Eggertsson and Woodford (2003). The zero bound on interest rates and optimal monetary policy. Brookings Papers on Economic Activity 2003(1), 139–211. I Woodford (2003). Interest and prices: foundations of a theory of monetary policy. Princeton University Press, Princeton. 2 / 31 Introduction The model Interpretation Research questions Findings Some questions I Monetary policy is ordinarily considered solely in terms of the choice of an operating target for a short-term nominal interest rate. I During the crisis, the appropriate size of the central bank’s balance sheet was part of the debate (Fig. 1 and Fig. 2). I Does it make sense to regard the supply of bank reserves (or perhaps the monetary base) as an alternative or superior operating target for monetary policy ? I Does this (as some would argue) become the only important monetary policy decision once the overnight rate (the federal funds rate) has reached the zero lower bound ? I How should this additional potential dimension of policy be used ? 3 / 31 Introduction The model Interpretation Research questions Findings Cúrdia and Woodford: what do they do ? I They analyze additional dimensions of central bank policy I I I size and composition of the central-bank balance sheet interest rate paid on reserves operating target for the federal funds rate 4 / 31 Introduction The model Interpretation Research questions Findings Cúrdia and Woodford: what do they …nd ? I no role for quantitative easing as an additional tool of stabilization policy, even at ZLB. I there may be a role for central-bank credit policy, or for targeted asset purchases, when private …nancial markets are su¢ ciently deteriorated. I when they are, as indicated by signi…cant increases in interest-rate spreads, one must be cautious in drawing conclusions about the welfare consequences of credit policy. I ZLB is neither necessary nor su¢ cient for active credit policy to be welfare-improving. 5 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Assumptions I No endogenous variations in the capital stock. I No distinction between the household and …rm sectors of the economy I Instead they treat all private expenditure as the expenditure of in…nite-lived household-…rms I No consequences of investment spending for the evolution of the economy’s productive capacity I Instead they treat all private expenditure as if it were non-durable consumer expenditure I Monopolistic competition in goods markets. I Sticky prices à la Calvo (1983) I Two household types: savers (s) and borrowers (b). 6 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Representative household I Households seek to maximize: +∞ E0 8 < ∑ β t : u τ ( i ) ( ct ( i ) ; ξ t ) t =0 t Z1 υτt (i ) (ht (i, j ) ; ξ t ) dj 0 where τ t (i ) indicates household’s type in period t and u τ t (i ) ( ct ( i ) ; ξ t ) = c1 στ 1 (C̄tτ ) 1 στ 1 9 = ; (1) στ 1 (2) where C̄tτ is an exogenous type-speci…c disturbance indicating variation in aggregate spending opportunities. I The index ct (i ) is a Dixit–Stiglitz aggregator of the household’s purchases of di¤erentiated goods, with elasticity of substitution θ between any two goods. 7 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Household’s types I I I I I I Each agent’s type τ t (i ) evolves as an independent two-state Markov chain. Each period, an event occurs with probability 1 δ (for 0 δ < 1) which results in a new type for the household being drawn; otherwise it remains the same as in the previous period. When a new type is drawn, it is b with probability π b > 0 and s with probability π s < 1, where π b + π s = 1. ucb (c; ξ ) > ucs (c; ξ ) for all levels of expenditure c in the range that occur in equilibrium. A change in a household’s type changes its relative impatience to consume. Current impatience of households to consume is changed by the exogenous disturbances C̄tτ . 8 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Representative …rm I Continuum of di¤erentiated goods, each produced by a monopolistically competitive supplier, with a production technology for each good j of the form yt (i ) = At ht (j )1/φ I (3) where φ indicates the degree of diminishing returns, and At is an exogenous productivity shock, common to all goods. The household similarly supplies a continuum of di¤erent types of specialized labor, indexed by j, that are hired by …rms in di¤erent sectors of the economy ψ τ 1 +v υτt (i ) (ht (i, j ) ; ξ t ) = h H̄t v (4) 1+v where v is the inverse of the Frisch elasticity of labor supply for both types, and H̄t is an exogenous disturbance, also common to both types. 9 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Summarizing the economy (1) λbt = 1 + itd (1 + ω t ) βEt " ( δ + (1 + (1 λb δ) π b ) Πtt++11 δ ) (1 λs π b ) Πtt++11 # (5) where λbt is the marginal utility of expenditure of borrowers, itb is b d the deposit/policy rate, ω t = i1t +iidt is the spread between t borrowing and deposit rates, Πt is the gross in‡ation rate, and λst is marginal utility of expenditure of savers de…ned as " # λbt+1 1 δ π ( ) b Π t +1 λst = 1 + itd βEt (6) λs + (δ + (1 δ) (1 π b )) Πtt++11 10 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Summarizing the economy (2) Kt = Λ λbt , λst p (1 + ω y ) ψµwt H̄t v µ λ̃ λbt , λst h i θ (1 + ω ) +αβEt Πt +1 y Kt +1 Yt At 1 +ω y where Kt is an arti…cial variable used in recursive version of in‡ation dynamics, Λ and λ̃ are di¤erent weighted average functions, and µwt is the wage markup. h i Ft = Λ λbt , λst (1 τ t ) Yt + αβEt Πtθ+11 Ft +1 (7) (8) where Ft is an arti…cial variable used in recursive version of in‡ation dynamics, and τ t is the marginal tax rate. 11 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Summarizing the economy (3) Real per capita private debt evolves according to (1 + π b ω t ) bt = π b π s B λbt , λst , Yt , ∆t ; ξ t + δ bt Yt = π b C̄tb λbt σb 1 (1 + ω t π b btg g 1 ) + π b bt 1 + π s C̄ts (λst ) σs 1 + itd Πt + Gt + Ξ t (9) 1 (10) where btg is the total outstanding real public debt, Gt represents government consumption, and Ξt is the total intermediation resource costs, including both private and central bank. ∆t = α∆t θ (1 + ω y ) 1 Πt + (1 α) 1 αΠtθ 1 α 1 ! θ (1θ+ω1 y ) (11) where ∆t measures price dispersion. 12 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Summarizing the economy (4) 1 1 αΠtθ 1 α = { Ft Kt θ 1 1 +θω y (12) η 1 + Ξ̃t+ (13) where Lcb is the real quantity of lending by the central bank to the t private sector, χ̃t (χ̃t+ ) is a multiplicative (additive) shock to default rate, Ξ̃t (Ξ̃t+ ) is a multiplicative (additive) private intermediation resource cost shock. ω t = (1 + {) χ̃t bt Ξt = Ξ̃t bt Lcb t Lcb t η + χ̃t+ + η Ξ̃t bt + Ξ̃t+ bt Lcb t cb Lcb + Ξ̃cb t t Lt (14) where Ξ̃cb t is a resource cost function. 13 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Financial intermediaries (1) The private intermediaries resource cost, given the satiation of reserves, is given by: Ξpt (L; ξ t ) = Ξ̃t Lt + Ξ̃t+ L η where L is the amount of privately intermediated credit, and η Fraudulent credit loss is χ (L; ξ t ) = χ̃t L1t +{ + χ̃t+ L (15) 1. (16) where { 0. Central bank lending resource cost Ξcb Lcb t where η cb η cb = Ξ̃cb t L (17) 1. 14 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Financial intermediaries (2) Intermediary chooses dt such that 1 + itd dt = 1 + itb Lt + (1 + itm ) mt (18) where mt is the quality of real reserves held at the central bank paying a nominal interest yield itm . Deposits not used to …nance either loans or the acquisition of reserve balances are distributed as earnings to its shareholders dt mt Lt χt (Lt ) Ξpt (Lt ; mt ) (19) Market-clearing in the credit market requires that bt = Lcb t + Lt (20) 15 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Financial intermediaries (3) F.O.C. /Lt ∂Ξpt (Lt ; mt ) ∂χt (Lt ) i b itd + = ωt = t ∂Lt ∂Lt 1 + itd F.O.C. /mt ∂Ξpt (Lt ; mt ) itb itm = δm t = ∂mt 1 + itd (21) (22) Eq. 22 determines the equilibrium di¤erential between the interest paid on deposits and that paid on reserves at the central bank. 16 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Dimensions of central-bank policy I In the model, central bank’s liabilities consist of the reserves Mt (which is also the monetary base in the simple model). I Central bank’s holdings of government debt is mt Lcb t (two variables chosen by the central bank) where 0 Lcb mt t I Positive quantity of public debt remains in the portfolios of g households2 : mt Lcb t + bt I Strong assumption: itm is assumed to be equal to the one private sector request reserves (i.e. the central bank receives the market-determined yield). Then, at equilibrium, itm = itb . In other words, the central bank cannot use this instrument in the model. 2 This constraint is never binding. 17 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Instruments of central-bank policy I itd is determined at each period by the system mt δm t I I mtd (Lt ; δm t ) 0 (23) where mtd (L; δm t ) represents the demand for reserves which equals the satiation level (m̄t (L)) when δm t = 0. For institutional reasons, it is not possible for the central bank to pay a negative interest rate on reserves, thus implying that 0 itm itd . To summarize, the central bank can play with the quantity of reserves Mt that are supplied, with the interest rate paid on those reserves itm (disabled here), and with the breakdown of central-bank assets between government debt and lending Lcb t to the private sector. 18 / 31 Introduction The model Interpretation Sectors and types Central bank policy Welfare Welfare objective I Optimal policy is considered: the objective of policy is the maximization of average expected utility such as +∞ Et 0 ∑ βt t0 Ut (24) t =t 0 where Ut refers to the household’s utility function used in Eq. 1. I See the paper for the demonstration why arguments Ut = U (Yt , Ωt , Ξt , ∆t ; ξ t ) , where Ωt = λbt /λst , su¢ ce to determine welfare, and the way each of them a¤ects welfare. 19 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Summary I Optimal policy with regard to the supply of reserves: taking as given (for now) the way in which the central bank chooses its operating target for the policy rate itd , and the state-contingent level of central-bank lending to the private sector (Lcb t ). I Simple result: optimal policy requires that intermediaries be satiated in reserves, i.e., that 8t Mt /Pt m̄t (Lt ). 20 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Is a reserve supply target needed? I E¢ cient condition: itm = itd i.e. δm t =0 I When the central bank acts to implement its target for the policy rate through open-market operations, it will automatically have to adjust the supply of reserves so as to satisfy δm t = 0. I No need of FOMC decision, bank’s sta¤ in charge of carrying out the necessary interventions is su¢ cient. 21 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Is there a role for quantitative easing? I By construction, the model implies that it is desirable to ensure that the supply of reserves never falls below a certain satiation level: m̄t (Lt ). I It then implies that there is no bene…t from supplying reserves beyond that level. I However, it can be desirable to supply reserves beyond m̄t (Lt ) if this is necessary in order to make the optimal quantity of central bank lending to the private sector consistent with 0 Lcb mt . t I See Fig. 3. 22 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion An other dimension of central-bank policy Adjustment of the composition of the asset side of the central bank’s balance sheet (taking as given the overall size of the balance sheet) Ξ̄pt (Lt ) = Ξpt (Lt ; m̄t (Lt )) (25) ω̄ t (Lt ) = ω t (Lt ; m̄t (Lt )) (26) Specifying the evolution of Ξpt and ω t as functions of the evolution of aggregate private credit, the equilibrium conditions of the model do not refer to the quantity of reserves or to the interest rate paid on reserves. 23 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion "Treasuries only" I According to the traditional doctrine of “Treasuries only”, the central bank should not vary the composition of its balance sheet as a policy tool; I Instead, it should avoid both balance-sheet risk and the danger of politicization by only holding (essentially riskless) Treasury securities at all times, while varying the size of its balance sheet to achieve its stabilization goals for the aggregate economy. 24 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Eggertsson and Woodford (2003) I Eggertsson and Woodford (2003) show that assets purchased by the central bank have no consequences for the equilibrium evolution of output, in‡ation or asset prices. I This irrelevance result does not hold, however, in the presence of credit frictions of the kind assumed here. I Proof: the di¤erence between the economy’s evolution under an optimal credit policy and under the constraint of “Treasuries only” (Fig. 6 to Fig. 12). 25 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Relaxing the “Treasuries only” restriction (1) I What is the marginal increase in the value of the welfare objective (Eq. 24) that is achieved by a marginal increase in Lcb t above zero in some period. I The marginal cost of central-bank lending required for ) is reported in …gures “Treasuries only” to be optimal (Ξcb,crit t such as i ϕω,t h p 00 00 p0 Ξcb,crit = Ξ̄ L + Ξ̄ L + χ L (27) ( ) ( ) ( ) t t t t t t t ϕΞ,t 0 where Ξ̄pt is the marginal resource cost of lending by private intermediaries. 26 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Relaxing the “Treasuries only” restriction (2) I Four di¤erent possible purely …nancial disturbances, each of which will be assumed to increase the value of ω̄ t (L̄) by the same number of percentage points: I I I I Additive shock: translates the schedule ω̄ t (Lt ) vertically by a constant amount; Multiplicative shock: multiply the entire schedule ω̄ t (Lt ) by some constant factor greater than 1. Ξ shock: disturbances that change the function Ξ̄t (Lt ); χ shock: disturbances that change the function χt (Lt ). I Fig. 4 shows that the degree to which a …nancial disturbance provides a justi…cation for active central-bank credit policy depends very much on the reason for the increase in spreads. I Fig. 5 shows how optimal vs. Taylor rules react, with or without ZLB. 27 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Optimal credit policy under alternative …nancial disturbances I Optimal state-contingent evolution of central-bank lending Lcb t , only the constraint that it be non-negative is imposed, and resource costs of loan origination and central-bank monitoring are taken into account. I Existence of a competitive loan market is still assumed : central-bank lends at the same (market-clearing) interest rate itb as the private intermediaries, who continue to lend even when the central-bank lends as well. I As previous results suggest, the degree to which active credit policy is optimal varies with the nature of the …nancial disturbance. I See Fig. 6 to Fig. 12. 28 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Segmented credit markets I In reality, there are many distinct credit markets, and many di¤erent parties to which the central-bank might consider lending. I For each of the segmented credit markets, we have Eq. 25 and Eq. 26. I Lending might be justi…ed in one or two speci…c markets while the corner solution remained optimal in the other markets. I Aggregate conditions will be one factor that a¤ects the shadow value of marginal reductions in the size of credit spreads : market-speci…c multiplier ϕω,t . 29 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Conclusion (1) I I I I I Analysis of additional dimensions of central-bank policy. Explicitly modeling the role of the central-bank balance sheet don’t imply any role for quantitative easing as an additional tool of stabilization policy, even when ZLB is reached. Maybe a role for central-bank credit policy (or for targeted asset purchases) when private …nancial markets are su¢ ciently impaired. It is only at times of unusual …nancial distress (i.e. when …nancial markets fail to ful…ll that function) that active credit policy will have substantial bene…ts. Even when …nancial markets are seriously disrupted, as indicated by signi…cant increases in interest-rate spreads, one must be cautious in drawing conclusions about the welfare consequences of credit policy. 30 / 31 Introduction The model Interpretation Reserve-supply policy Optimal credit policy Conclusion Conclusion (2) I ZLB does not necessarily involve welfare-improving active credit policy. I Interest-rate policy decisions are not constrained in any direct way by decisions about either the size or composition of the central bank’s balance sheet, as long as the central bank is willing to adjust the interest rate paid on reserves appropriately. I Fed "exit" strategy and nominal interest rate increase are not necessarily linked. 31 / 31