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Rediscounting Under Aggregate Risk with Moral Hazard

  • James T. E. Chapman
  • Antoine Martin

Freeman (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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Paper provided by Bank of Canada in its series Working Papers with number 07-51.

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Length: 30 pages
Date of creation: 2007
Date of revision:
Handle: RePEc:bca:bocawp:07-51
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  1. Edward J. Green, 1996. "Money and Debt in the Structure of Payments," Macroeconomics 9609002, EconWPA, revised 09 Sep 1996.
  2. Guido Tabellini & Scott Freeman, 1998. "The optimality of nominal contracts," Economic Theory, Springer, vol. 11(3), pages 545-562.
  3. 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.
  4. Ruilin Zhou, 2000. "Understanding intraday credit in large-value payment systems," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q III, pages 29-44.
  5. 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.
  6. Antoine Martin, 2002. "Optimal pricing of intra-day liquidity," Research Working Paper RWP 02-02, Federal Reserve Bank of Kansas City.
  7. 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.
  8. 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.
  9. James T. E. Chapman, 2008. "Policy Coordination in an International Payment System," Working Papers 08-17, Bank of Canada.
  10. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
  11. 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.
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