Rediscounting Under Aggregate Risk with Moral Hazard
AbstractFreeman (1999) proposes a model in which discount window lending and open market operations have different effects. This is important because in most of the literature, these policies are indistinguishable. However, Freeman's argument that the central bank should absorb losses associated with default to provide risk-sharing stands in stark contrast to the concern that central banks should limit their exposure to credit risk. We extend Freeman's model by introducing moral hazard. With moral hazard, the central bank should avoid absorbing losses and Freeman's argument breaks down. However, we show that policies resembling discount window lending and open market operations can still be distinguished in this new framework. The optimal policy is for the central bank to make a restricted number of creditors compete for funds. By restricting the number of agents, the central bank can limit the moral hazard problem. By making them compete with each other, the central bank can exploit market information that reveals the state of the economy.
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 07-51.
Length: 30 pages
Date of creation: 2007
Date of revision:
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Payment; clearing; and settlement systems; Financial markets; Central bank research;
Other versions of this item:
- James T.E. Chapman & Antoine Martin, 2013. "Rediscounting under Aggregate Risk with Moral Hazard," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(4), pages 651-674, 06.
- James T. E. Chapman & Antoine Martin, 2007. "Rediscounting under aggregate risk with moral hazard," Staff Reports 296, Federal Reserve Bank of New York.
- G20 - Financial Economics - - Financial Institutions and Services - - - General
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-11-03 (All new papers)
- NEP-CBA-2007-11-03 (Central Banking)
- NEP-MAC-2007-11-03 (Macroeconomics)
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