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Conventional and Unconventional Monetary Policy with Endogenous Collateral Constraints

Listed author(s):
  • Araujo, Aloisio
  • Schommer, Susan
  • Woodford, Michael

We consider the effects of central-bank purchases of a risky asset, financed by issuing riskless nominal liabilities (reserves), as an additional dimension of policy alongside “conventional” monetary policy (central-bank control of the riskless nominal interest rate), in a general-equilibrium model of asset pricing and risk sharing with endogenous collateral constraints of the kind proposed by Geanakoplos (1997). When sufficient collateral exists for collateral constraints not to bind for any agents, we show that central-bank asset purchases have no effects on either real or nominal variables, despite the differing risk characteristics of the assets purchased and the ones issued to finance these purchases. At the same time, the existence of collateral constraints allows our model to capture the common view that large enough central-bank purchases would eventually have to effect asset prices. But even when central-bank purchases raise the price of the asset, owing to binding collateral constraints, the effects need not be the ones commonly assumed. We show that under some circumstances, central-bank purchases relax financial constraints, increase aggregate demand, and may even achieve a Pareto improvement; but in other cases, they may tighten financial constraints, reduce aggregate demand, and lower welfare. The latter case is almost certainly the one that arises if central-bank purchases are sufficiently large.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9995.

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Date of creation: May 2014
Handle: RePEc:cpr:ceprdp:9995
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  1. Aloisio Araújo & Jaime Orrillo & Mario R. Páscoa, 2000. "Equilibrium with Default and Endogenous Collateral," Mathematical Finance, Wiley Blackwell, vol. 10(1), pages 1-21.
  2. Aloisio Araujo & Mário Rui Páscoa & Juan Pablo Torres-Martínez, 2002. "Collateral Avoids Ponzi Schemes in Incomplete Markets," Econometrica, Econometric Society, vol. 70(4), pages 1613-1638, July.
  3. Cúrdia, Vasco & Woodford, Michael, 2011. "The central-bank balance sheet as an instrument of monetarypolicy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 54-79, January.
  4. Araújo, Aloísio & Kubler, Felix & Schommer, Susan, 2012. "Regulating collateral-requirements when markets are incomplete," Journal of Economic Theory, Elsevier, vol. 147(2), pages 450-476.
  5. Wallace, Neil, 1981. "A Modigliani-Miller Theorem for Open-Market Operations," American Economic Review, American Economic Association, vol. 71(3), pages 267-274, June.
  6. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
  7. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
  8. David Bowman & Etienne Gagnon & Michael P. Leahy, 2010. "Interest on excess reserves as a monetary policy instrument: the experience of foreign central banks," International Finance Discussion Papers 996, Board of Governors of the Federal Reserve System (U.S.).
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