Optimal monetary policy in a collateralized economy

Abstract

Collateral plays a real role in an economy. Mortgage-backed and asset-backed securities (MBS/ABS) produced by the private sector are imperfect substitutes for Treasuries as collateral. The ratio of MBS/ABS to Treasuries is positively related to financial fragility because privately-produced collateral is risky. We analyze optimal central bank policy in a dynamic game between the central bank and private agents. In equilibrium, the central bank sometimes optimally triggers recessions to reduce systemic fragility.

Inequality-constrained monetary policy in a financialized economy

“…To sum up, monetary policy can help the system to alleviate the problems associated with inequality and financial fragility by (i) providing all the liquidity required by financial institutions and (ii) keeping the policy rate at a low level (even at the ZLB) as long as possible Giri et al (2019) The financial burden can be kept sustainable for a while until the inevitable policy rate hike in response to raising inflation arrives and the crisis-prone system collapses. In fact, the central bank sometimes can trigger recessions to reduce financial fragility, as shown by Gorton and He (2021): when the ratio of privately produced "safe debt" (e.g. ABM, MBS, etc.)…”

“…the likelihood of a crisis) is increasing in the ABS/MBS-to-Treasuries ratio, and this reduces welfare. According to Gorton and He (2021), the central bank can incorporate financial fragility in its policy and pursue (this kind of) macroprudential policy. This would imply even triggering a recession if the welfare costs associated with a recession are smaller than the gain associated with reduced financial fragility.…”