A model of unconventional monetary policy

We develop a quantitative monetary DSGE model with financial intermediaries that face endogenously determined balance sheet constraints. We then use the model to evaluate the effects of the central bank using unconventional monetary policy to combat a simulated financial crisis. We interpret unconventional monetary policy as expanding central bank credit intermediation to offset a disruption of private financial intermediation. Within our framework the central bank is less efficient than private intermediaries at making loans but it has the advantage of being able to elastically obtain funds by issuing riskless government debt. Unlike private intermediaries, it is not balance sheet constrained. During a crisis, the balance sheet constraints on private intermediaries tighten, raising the net benefits from central bank intermediation. These benefits may be substantial even if the zero lower bound constraint on the nominal interest rate is not binding. In the event this constraint is binding, though, these net benefits may be significantly enhanced.

Research Highlights►We develop a macroeconomic model with financial intermediation, which allows the intermediaries (banks) to issue outside equity as well as short term debt. This makes bank risk exposure an endogenous choice. ►The goal is to have a model that can not only capture a crisis when banks are highly vulnerable to risk, but can also account for why banks adopt such a risky portfolio structure in the first place. ►We use the model to assess quantitatively how perceptions of fundamental risk and of government credit policy in a crisis affect the vulnerability of the financial system ex ante. ►We also study the quantitative effects of macro-prudential policies designed to offset incentives for risk-taking.