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Alternative central bank credit policies for liquidity provision in a model of payments

  • David C. Mills

I explore alternative central bank policies for liquidity provision in a model of payments. I use a mechanism design approach so that agents' incentives to default are explicit and contingent on the credit policy designed. In the first policy, the central bank invests in costly enforcement and charges an interest rate to recover costs. I show that the second best solution is not distortionary. In the second policy, the central bank requires collateral. If collateral does not bear an opportunity cost, then the solution is first best. Otherwise, the second best is distortionary because collateral serves as a binding credit constraint.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2005-55.

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Date of creation: 2005
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Handle: RePEc:fip:fedgfe:2005-55
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  1. Ruilin Zhou, 2000. "Understanding intraday credit in large-value payment systems," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q III, pages 29-44.
  2. Bech, Morten L. & Garratt, Rod, 2003. "The intraday liquidity management game," Journal of Economic Theory, Elsevier, vol. 109(2), pages 198-219, April.
  3. Angelini, Paolo, 1998. "An analysis of competitive externalities in gross settlement systems," Journal of Banking & Finance, Elsevier, vol. 22(1), pages 1-18, January.
  4. Jeffrey Lacker, 2001. "Online Appendix to Collateralized Debt as the Optimal Contract," Technical Appendices lacker01, Review of Economic Dynamics.
  5. Narayana R. Kocherlakota, 1996. "Money is memory," Staff Report 218, Federal Reserve Bank of Minneapolis.
  6. Charles M. Kahn & William Roberds, 1999. "Real-time gross settlement and the costs of immediacy," FRB Atlanta Working Paper 98-21, Federal Reserve Bank of Atlanta.
  7. Townsend, Robert M, 1989. "Currency and Credit in a Private Information Economy," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1323-44, December.
  8. Martin, Antoine, 2004. "Optimal pricing of intraday liquidity," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 401-424, March.
  9. Rochet, Jean-Charles & Tirole, Jean, 1996. "Controlling Risk in Payment Systems," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 832-62, November.
  10. Kobayakawa, Shuji, 1997. "The Comparative Analysis of Settlement Systems," CEPR Discussion Papers 1667, C.E.P.R. Discussion Papers.
  11. Jeffrey M. Lacker, 1998. "Collateralized debt as the optimal contract," Working Paper 98-04, Federal Reserve Bank of Richmond.
  12. 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.
  13. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
  14. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February.
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