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Central Bank Haircut Policy

Listed author(s):
  • James Chapman, Jonathan Chiu, and Miguel Molico

We present a model of central bank collateralized lending to study the optimal choice of the haircut policy. We show that a lending facility provides a bundle of two types of insurance: insurance against liquidity risk as well as insurance against downside risk of the collateral. Setting a haircut therefore involves balancing the trade-off between relaxing the liquidity constraints of agents on one hand, and increasing potential inflation risk and distorting the portfolio choices of agents on the other. We argue that the optimal haircut is higher when the central bank is unable to lend exclusively to agents who actually need liquidity. Finally, for an unexpected drop in the haircut, the central bank can be more aggressive than when setting a permanent level of the haircut.

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File URL: http://www.bankofcanada.ca/wp-content/uploads/2010/10/wp10-23.pdf
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Paper provided by Bank of Canada in its series Staff Working Papers with number 10-23.

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Length: 44 pages
Date of creation: 2010
Handle: RePEc:bca:bocawp:10-23
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