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The interaction between the central bank and government in tail risk scenarios

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  • Jan Willem van den End
  • Marco Hoeberichts

Abstract

We analyse the relationship between tail risk and crisis measures by governments and the central bank. Using an adjusted Merton model in a game theoretical set-up, the analysis shows that the participation constraint for interventions by the central bank and the governments is less binding if the risk of contagion is high. The strategic interaction between governments and the central bank also influences the effectiveness of the interventions. A joint effort of both the governments and central bank leads to a better outcome. To prevent a bad equilibrium a sizable commitment by both players is required. Our stylized model sheds light on the strategic interaction between EMU governments and the Eurosystem in the context of the Outright Monetary Transactions program (OMT).

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Bibliographic Info

Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 352.

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Date of creation: Oct 2012
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Handle: RePEc:dnb:dnbwpp:352

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Web page: http://www.dnb.nl/en/
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Keywords: Financial crisis; Monetary policy; Central banks; Policy coordination;

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  1. Dixit, Avinash & Lambertini, Luisa, 2001. "Monetary-fiscal policy interactions and commitment versus discretion in a monetary union," European Economic Review, Elsevier, vol. 45(4-6), pages 977-987, May.
  2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  3. Xin Zhang & Bernd Schwaab & Andre Lucas, 2011. "Conditional Probabilities and Contagion Measures for Euro Area Sovereign Default Risk," Tinbergen Institute Discussion Papers 11-176/2/DSF29, Tinbergen Institute, revised 28 Jun 2012.
  4. Daniel Kapp, 2012. "The optimal size of the European Stability Mechanism: A cost-benefit analysis," DNB Working Papers 349, Netherlands Central Bank, Research Department.
  5. Michael Gapen & Dale Gray & Cheng Hoon Lim & Yingbin Xiao, 2008. "Measuring and Analyzing Sovereign Risk with Contingent Claims," IMF Staff Papers, Palgrave Macmillan, vol. 55(1), pages 109-148, April.
  6. Alberto Alesina, 1988. "Macroeconomics and Politics," NBER Chapters, in: NBER Macroeconomics Annual 1988, Volume 3, pages 13-62 National Bureau of Economic Research, Inc.
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