The Center for Financial Studies is a nonprofit research organization, supported by an associatio... more The Center for Financial Studies is a nonprofit research organization, supported by an association of more than 120 banks, insurance companies, industrial corporations and public institutions. Established in 1968 and closely affiliated with the University of Frankfurt, it provides a strong link between the financial community and academia. The CFS Working Paper Series presents the result of scientific research on selected topics in the field of money, banking and finance. The authors were either participants in the Center´s Research Fellow Program or members of one of the Center´s Research Projects. If you would like to know more about the Center for Financial Studies, please let us know of your interest.
The paper models the interaction between risk taking in the financial sector and central bank pol... more The paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. In that case, liquidity injection will make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. We show that unconditional free lending against good collateral, as suggested by the Bagehot Rule, fails to address the moral hazard problem: Even though we con...
In the wake of the recent European debt crisis, the European Central Bank (ECB) has grown signifi... more In the wake of the recent European debt crisis, the European Central Bank (ECB) has grown significantly in importance. As the crisis worsened, the ECB needed to take measures that went far beyond standard monetary policy operations - particularly with respect to its function as lender of last resort. It provided the banking sector with almost unlimited liquidity and, in addition, purchased government bonds of distressed countries outright. Eventually, in the summer of 2012, it followed through on its promise to do everything possible to save the euro as a common currency. This announcement temporarily stabilized financial markets and the countries in crisis. Nevertheless, compared to other central banks, the ECB is inhibited in its scope of activities: unlike, for example, the US Federal Reserve (Fed), the European Central Bank has no well-defined institutionally anchored fiscal backing. Consequently, the measures it can take are limited by the maximum loss it can incur. This also m...
Mit einer Kombination aus wiederholten Zinssenkungen und Haushaltsdefiziten bekampften die Vereini... more Mit einer Kombination aus wiederholten Zinssenkungen und Haushaltsdefiziten bekampften die Vereinigten Staaten ihre jungste Rezession. Findet in den USA eine bemerkenswerte Renaissance aktiver keynesianischer Stabilisierungspolitik statt? Konnen die Wirtschaftsprobleme Deutschlands durch Globalsteuerung gelost werden?
The article illustrates how the integration of modern theory of finance and stochastic dynamic ma... more The article illustrates how the integration of modern theory of finance and stochastic dynamic macroeconomic analysis provides a deeper understanding of the link between asset prices and consumption. It shows that this approach gives only a partial explanation for recent trends in US consumption. Comparing wealth effects in Anglo Saxon countries with continental Europe, the paper provides a perspective of the challenges for European monetary policy arising from wealth effects on consumption.
In this paper we present a three period setup to model central bank forward guidance in a liquidi... more In this paper we present a three period setup to model central bank forward guidance in a liquidity trap. We analyze the role of long-run and short-run price stickiness under discretion and commitment in a straightforward and intuitive way. Despite the impact of price rigidity on welfare being non-linear, losses under discretion are lowest with perfectly flexible prices. We show why the zero lower bound may still be binding even long after the shock has gone and characterize conditions when a commitment to hold nominal rates at zero for an extended period is optimal. We then introduce government spending and show that under persistently low policy rates optimal government spending becomes more front-loaded, while procyclical austerity fares worse than discretionary government spending.
Why do advanced economies fall into prolonged periods of economic stagnation, particularly in the... more Why do advanced economies fall into prolonged periods of economic stagnation, particularly in the aftermath of credit booms? We present a model of persistent aggregate demand shortage based on strong liquidity preferences of households, in which we incorporate financial imperfections to study the interactions between debt, liquidity and asset prices. We show that financially more deregulated economies are more likely to experience persistent stagnation. In the short run, credit booms can mask this structural aggregate demand deficiency. However, the resulting debt overhang permanently depresses spending in the long run since deleveraging becomes self-defeating because of debt deflation. These findings are in line with the macroeconomic developments in Japan during its lost decades and other advanced economies before and during the Great Recession.
In most banking models, money is merely modeled as medium for transaction, but in reality, money ... more In most banking models, money is merely modeled as medium for transaction, but in reality, money is also the most liquid asset for banks. Central banks do not only passively supply money to meet demand for transaction, as often assumed in these models, instead they also actively inject liquidity into market, taking banks' illiquid assets as collateral. We examine both roles of money in an integrated framework, in which banks are subject to aggregate illiquidity risk. With fixed nominal deposit contracts, the monetary economy with active central bank can replicate constrained efficient allocation. This allocation, however, cannot be implemented in market equilibrium without additional regulation: Due to moral hazard problems, banks invest excessively in illiquid assets, forcing the central bank to provide liquidity at low interest rates. We show that interest rate policy to reduce systemic liquidity risk on its own is dynamically inconsistent. Instead, the constrained efficient solution can be achieved by imposing ex ante liquidity coverage requirement.
Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch ge... more Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence.
If the documents have been made available under an Open Content Licence (especially Creative Comm... more If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence.
We study monetary policy at the ZLB in a traceable three-period model, in which pricelevel target... more We study monetary policy at the ZLB in a traceable three-period model, in which pricelevel targeting emerges endogenously in the welfare function. We characterize optimal pricelevel forward guidance under discretion and commitment. Potentially non-monotonic discretionary welfare losses are lowest with perfectly flexible prices. Price-level targeting introduces a new constraint on optimal forward guidance that restricts the credible amount of overshooting. With this constraint, the zero lower bound may be binding even after the shock has abated. We characterize conditions when the commitment to hold nominal rates at zero for an extended period is optimal. Finally, we introduce government spending and show that under persistently low policy rates optimal government spending becomes more front-loaded, while procyclical austerity fares worse than discretionary government spending.
c CESifo Traditionally, aggregate liquidity shocks are modeled as exogenous events. This paper an... more c CESifo Traditionally, aggregate liquidity shocks are modeled as exogenous events. This paper analyzes the adequate policy response to endogenous exposure to systemic liquidity risk. We analyze the feedback between lender-of-last-resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante is a crucial requirement for sensible lender-of-last-resort policy. In addition, we analyze the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that both policies are strictly inferior to imposing minimum liquidity standards ex ante combined with lender-of-last-resort policy.
The Center for Financial Studies is a nonprofit research organization, supported by an associatio... more The Center for Financial Studies is a nonprofit research organization, supported by an association of more than 120 banks, insurance companies, industrial corporations and public institutions. Established in 1968 and closely affiliated with the University of Frankfurt, it provides a strong link between the financial community and academia. The CFS Working Paper Series presents the result of scientific research on selected topics in the field of money, banking and finance. The authors were either participants in the Center´s Research Fellow Program or members of one of the Center´s Research Projects. If you would like to know more about the Center for Financial Studies, please let us know of your interest.
The paper models the interaction between risk taking in the financial sector and central bank pol... more The paper models the interaction between risk taking in the financial sector and central bank policy for the case of pure illiquidity risk. It is shown that, when bad states are highly unlikely, public provision of liquidity may improve the allocation, even though it encourages more risk taking (less liquid investment) by private banks. In general, however, there is an incentive of financial intermediaries to free ride on liquidity in good states, resulting in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. In that case, liquidity injection will make the free riding problem even worse. The results show that even in the case of pure illiquidity risk, there is a serious commitment problem for central banks. We show that unconditional free lending against good collateral, as suggested by the Bagehot Rule, fails to address the moral hazard problem: Even though we con...
In the wake of the recent European debt crisis, the European Central Bank (ECB) has grown signifi... more In the wake of the recent European debt crisis, the European Central Bank (ECB) has grown significantly in importance. As the crisis worsened, the ECB needed to take measures that went far beyond standard monetary policy operations - particularly with respect to its function as lender of last resort. It provided the banking sector with almost unlimited liquidity and, in addition, purchased government bonds of distressed countries outright. Eventually, in the summer of 2012, it followed through on its promise to do everything possible to save the euro as a common currency. This announcement temporarily stabilized financial markets and the countries in crisis. Nevertheless, compared to other central banks, the ECB is inhibited in its scope of activities: unlike, for example, the US Federal Reserve (Fed), the European Central Bank has no well-defined institutionally anchored fiscal backing. Consequently, the measures it can take are limited by the maximum loss it can incur. This also m...
Mit einer Kombination aus wiederholten Zinssenkungen und Haushaltsdefiziten bekampften die Vereini... more Mit einer Kombination aus wiederholten Zinssenkungen und Haushaltsdefiziten bekampften die Vereinigten Staaten ihre jungste Rezession. Findet in den USA eine bemerkenswerte Renaissance aktiver keynesianischer Stabilisierungspolitik statt? Konnen die Wirtschaftsprobleme Deutschlands durch Globalsteuerung gelost werden?
The article illustrates how the integration of modern theory of finance and stochastic dynamic ma... more The article illustrates how the integration of modern theory of finance and stochastic dynamic macroeconomic analysis provides a deeper understanding of the link between asset prices and consumption. It shows that this approach gives only a partial explanation for recent trends in US consumption. Comparing wealth effects in Anglo Saxon countries with continental Europe, the paper provides a perspective of the challenges for European monetary policy arising from wealth effects on consumption.
In this paper we present a three period setup to model central bank forward guidance in a liquidi... more In this paper we present a three period setup to model central bank forward guidance in a liquidity trap. We analyze the role of long-run and short-run price stickiness under discretion and commitment in a straightforward and intuitive way. Despite the impact of price rigidity on welfare being non-linear, losses under discretion are lowest with perfectly flexible prices. We show why the zero lower bound may still be binding even long after the shock has gone and characterize conditions when a commitment to hold nominal rates at zero for an extended period is optimal. We then introduce government spending and show that under persistently low policy rates optimal government spending becomes more front-loaded, while procyclical austerity fares worse than discretionary government spending.
Why do advanced economies fall into prolonged periods of economic stagnation, particularly in the... more Why do advanced economies fall into prolonged periods of economic stagnation, particularly in the aftermath of credit booms? We present a model of persistent aggregate demand shortage based on strong liquidity preferences of households, in which we incorporate financial imperfections to study the interactions between debt, liquidity and asset prices. We show that financially more deregulated economies are more likely to experience persistent stagnation. In the short run, credit booms can mask this structural aggregate demand deficiency. However, the resulting debt overhang permanently depresses spending in the long run since deleveraging becomes self-defeating because of debt deflation. These findings are in line with the macroeconomic developments in Japan during its lost decades and other advanced economies before and during the Great Recession.
In most banking models, money is merely modeled as medium for transaction, but in reality, money ... more In most banking models, money is merely modeled as medium for transaction, but in reality, money is also the most liquid asset for banks. Central banks do not only passively supply money to meet demand for transaction, as often assumed in these models, instead they also actively inject liquidity into market, taking banks' illiquid assets as collateral. We examine both roles of money in an integrated framework, in which banks are subject to aggregate illiquidity risk. With fixed nominal deposit contracts, the monetary economy with active central bank can replicate constrained efficient allocation. This allocation, however, cannot be implemented in market equilibrium without additional regulation: Due to moral hazard problems, banks invest excessively in illiquid assets, forcing the central bank to provide liquidity at low interest rates. We show that interest rate policy to reduce systemic liquidity risk on its own is dynamically inconsistent. Instead, the constrained efficient solution can be achieved by imposing ex ante liquidity coverage requirement.
Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch ge... more Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence.
If the documents have been made available under an Open Content Licence (especially Creative Comm... more If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence.
We study monetary policy at the ZLB in a traceable three-period model, in which pricelevel target... more We study monetary policy at the ZLB in a traceable three-period model, in which pricelevel targeting emerges endogenously in the welfare function. We characterize optimal pricelevel forward guidance under discretion and commitment. Potentially non-monotonic discretionary welfare losses are lowest with perfectly flexible prices. Price-level targeting introduces a new constraint on optimal forward guidance that restricts the credible amount of overshooting. With this constraint, the zero lower bound may be binding even after the shock has abated. We characterize conditions when the commitment to hold nominal rates at zero for an extended period is optimal. Finally, we introduce government spending and show that under persistently low policy rates optimal government spending becomes more front-loaded, while procyclical austerity fares worse than discretionary government spending.
c CESifo Traditionally, aggregate liquidity shocks are modeled as exogenous events. This paper an... more c CESifo Traditionally, aggregate liquidity shocks are modeled as exogenous events. This paper analyzes the adequate policy response to endogenous exposure to systemic liquidity risk. We analyze the feedback between lender-of-last-resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante is a crucial requirement for sensible lender-of-last-resort policy. In addition, we analyze the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that both policies are strictly inferior to imposing minimum liquidity standards ex ante combined with lender-of-last-resort policy.
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Papers by Gerhard Illing