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Should Central Banks Take On Credit-Risk?

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  • Gomez-Ruano, Gerardo

Abstract

Central banks have a long tradition of minimizing their exposure to credit-risk. The Federal Reserve’s response to the recent financial crisis, which entailed greater risk-taking, has raised the question of whether such ‘unusual’ practices are desirable. This paper addresses the vacuum in the literature with a highly simplified model that has nevertheless the characteristics missing in the literature: it is a monetary dynamic stochastic general equilibrium model with an inflation-targeting central bank, aggregate risk, bankruptcy, and it is tractable. The main contribution is showing that, in an economy with bankruptcy rights and considerably indebted households, a Central Bank that operates exclusively with risk-free assets effects important distortions; in particular, it benefits the failure-free industries and punishes the failure-prone ones. Thus, on average, it takes longer for the economy to recover and risk-taking behavior is pro-cyclical. This is even with complete financial markets, perfect competition, both well-behaved production technologies and preferences, as well as flexible prices. Other results include conditions under which the behavior of the Credit-Spread is pro-cyclical or counter-cyclical (despite of a constant probability of failure). Proposals for avoiding the aforementioned distortions, and implications for the solution of the Zero Lower Bound problem, are provided at the end.

Suggested Citation

  • Gomez-Ruano, Gerardo, 2014. "Should Central Banks Take On Credit-Risk?," MPRA Paper 93633, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:93633
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    File URL: https://mpra.ub.uni-muenchen.de/93633/2/MPRA_paper_93633.pdf
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    References listed on IDEAS

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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Central Bank; Monetary Policy; Default; Bankruptcy; Cash-in-Advance Models; Inflation Targeting; Credit Spreads; Zero Lower Bound;
    All these keywords.

    JEL classification:

    • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy
    • E13 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Neoclassical
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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