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

Author

Listed:
  • 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).

Suggested Citation

  • Jan Willem van den End & Marco Hoeberichts, 2012. "The interaction between the central bank and government in tail risk scenarios," DNB Working Papers 352, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:dnbwpp:352
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    File URL: https://www.dnb.nl/en/binaries/Working%20Paper%20352_tcm47-279705.pdf
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    References listed on IDEAS

    as
    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. 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.
    3. Janus, Paweł & Koopman, Siem Jan & Lucas, André, 2014. "Long memory dynamics for multivariate dependence under heavy tails," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 187-206.
    4. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    5. 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 449-470, May.
    6. Daniel Kapp, 2012. "The optimal size of the European Stability Mechanism: A cost-benefit analysis," DNB Working Papers 349, Netherlands Central Bank, Research Department.
    7. Alberto Alesina, 1988. "Macroeconomics and Politics," NBER Chapters,in: NBER Macroeconomics Annual 1988, Volume 3, pages 13-62 National Bureau of Economic Research, Inc.
    8. Bernd Schwaab, 2012. "Conditional probabilities and contagion measures for euro area sovereign default risk," Research Bulletin, European Central Bank, vol. 17, pages 6-11.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Financial crisis; Monetary policy; Central banks; Policy coordination;

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • G01 - Financial Economics - - General - - - Financial Crises
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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