Should Central Banks Take On Credit-Risk?

Gomez-Ruano, Gerardo (2014): Should Central Banks Take On Credit-Risk?

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Central Bank; Monetary Policy; Default; Bankruptcy; Cash-in-Advance Models; Inflation Targeting; Credit Spreads; Zero Lower Bound
• Subjects: E - Macroeconomics and Monetary Economics > E0 - General > E02 - Institutions and the Macroeconomy; E - Macroeconomics and Monetary Economics > E1 - General Aggregative Models > E13 - Neoclassical; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E42 - Monetary Systems ; Standards ; Regimes ; Government and the Monetary System ; Payment Systems; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E51 - Money Supply ; Credit ; Money Multipliers; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

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