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Rediscounting under Aggregate Risk with Moral Hazard

  • JAMES T.E. CHAPMAN
  • ANTOINE MARTIN

In a 1999 paper, Freeman proposes a model in which discount window lending and open market operations have different outcomes - an important development because in most of the literature the results of these policy tools are indistinguishable. Freeman's conclusion that the central bank should absorb losses related to default to provide risk-sharing goes against 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, contrary to Freeman's argument. However, we show that the outcomes of discount window lending and open market operations can still be distinguished in this new framework. The optimal policy would be 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. And by making agents compete with each other, the central bank can exploit market information that reveals the state of the economy.

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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 45 (2013)
Issue (Month): 4 (06)
Pages: 651-674

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Handle: RePEc:mcb:jmoncb:v:45:y:2013:i:4:p:651-674
Contact details of provider: Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

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  1. Guido Tabellini & Scott Freeman, 1998. "The optimality of nominal contracts," Economic Theory, Springer, vol. 11(3), pages 545-562.
  2. James T. E. Chapman, 2008. "Policy Coordination in an International Payment System," Working Papers 08-17, Bank of Canada.
  3. Brian F. Madigan & William R. Nelson, 2002. "Proposed revision to the Federal Reserve's discount window lending programs," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jul, pages 313-319.
  4. Fujiki, Hiroshi, 2003. "A model of the Federal Reserve Act under the international gold standard system," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1333-1350, September.
  5. Stacy Panigay Coleman, 2002. "The evolution of the Federal Reserve's intraday credit policies," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Feb, pages 67-84.
  6. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
  7. Edward J. Green, 1999. "Money and debt in the structure of payments," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Spr, pages 13-29.
  8. Ruilin Zhou, 2000. "Understanding intraday credit in large-value payment systems," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q III, pages 29-44.
  9. Martin, Antoine, 2004. "Optimal pricing of intraday liquidity," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 401-424, March.
  10. Xavier Freixas & Jean-Charles Rochet & Bruno M. Parigi, 2004. "The Lender of Last Resort: A Twenty-First Century Approach," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1085-1115, December.
  11. David C. Mills, Jr, 2004. "Mechanism Design and the Role of Enforcement in Freeman's Model of Payments," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(1), pages 219-236, january.
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