Introduction The literature The model Results Conclusion Credit Spreads and the Zero Bound on Interest Rates I. Correia, F . De Fiore, P . Teles and O. Tristani Banco de Portugal and ECB CRETE, July 2013 1 / 28
Introduction The literature The model Results Conclusion Motivation • Literature on the ZLB as a constraint to monetary policy. • Sticky prices and preference shocks • Preference shock that lowers the natural rate of interest to low negative numbers • Cannot lower the nominal rate or increase the inflation rate to match the natural rate. • Deflation and high real interest rates. • During the financial crisis: real interest rates were high because of credit spreads, not because of deflation. 2 / 28
Introduction The literature The model Results Conclusion Real interest rates vs credit spreads in EA 4 3 2 1 0 2002-Q3 2003-Q3 2004-Q3 2005-Q3 2006-Q3 2007-Q3 2008-Q3 2009-Q3 2010-Q3 2011-Q3 2012-Q3 EONIA rate Expected inflation rate (EA) Realised inflation rate (EA) 3 2 1 0 -1 -2 2002-Q3 2003-Q3 2004-Q3 2005-Q3 2006-Q3 2007-Q3 2008-Q3 2009-Q3 2010-Q3 2011-Q3 2012-Q3 Credit spread (EA) Real interest rate (EA) Legend: percentage points, annually. Source: Datastream, SDW, Eurostat, World Economic Survey. 3 / 28
Introduction The literature The model Results Conclusion Real interest rates vs credit spreads in US 6 4 2 0 -2 2002-Q3 2003-Q3 2004-Q3 2005-Q3 2006-Q3 2007-Q3 2008-Q3 2009-Q3 2010-Q3 2011-Q3 2012-Q3 FED funds rate Expected inflation rate (US) Realised inflation rate (US) 6 4 2 0 -2 2002-Q3 2003-Q3 2004-Q3 2005-Q3 2006-Q3 2007-Q3 2008-Q3 2009-Q3 2010-Q3 2011-Q3 2012-Q3 Credit spread (US) Real interest rate (US) Legend: percentage points, annually. Source: Datastream, SDW, Eurostat, World Economic Survey. 4 / 28
Introduction The literature The model Results Conclusion Questions • Is the ZLB a constraint in models where credit spreads matter? • In the sticky price model, taxes can be used to overcome the ZLB. Can taxes be used to overcome the ZLB when interest rates are high because of credit spreads? • What other policies can be used to affect lending rates and credit spreads? 5 / 28
Introduction The literature The model Results Conclusion ZLB in sticky price models Eggertsson and Woodford (BPEA, 2003): • Preference shock that lowers the natural rate of interest to low negative numbers. Lower the nominal rate to zero. With inflation could match the natural rate. Without commitment, there’s deflation instead. The downturn could be arbitrarily large. The use of forward guidance. Correia, Fahri, Nicolini and Teles (AER, 2013): • Unconventional fiscal policy: zero producer price inflation and a path for consumption taxes that generates expected inflation; neutralize the distortion with appropriate choice of other taxes. • With lump-sum taxes, first-best allocation. Time-consistent. • Without lump-sum taxes, second-best. But ZLB is not a constraint. 6 / 28
Introduction The literature The model Results Conclusion Credit policy and the ZLB Gertler and Karadi (JME, 2011): • A model with financial frictions and capital quality shocks: a rule for direct credit provision by the central bank. Particularly useful at the ZLB. De Fiore and Tristani (2013): • Optimal mix of interest rate and credit provision at the ZLB. 7 / 28
Introduction The literature The model Results Conclusion This paper (so far) • Model where financial intermediaries face balance sheet constraints. • Financial shocks increase credit spreads and reduce output. • Without the ZLB, and with lump sum taxes: Negative policy rates. First-best. • With ZLB, with lump-sum taxes: Credit subsidies and first-best. • Without lump sum taxes: redit taxes/subsidies, second best.State contingent real debt with ex-post volatility of prices. • ZLB is not a restriction whether taxes are lump sum or not. 8 / 28
Introduction The literature The model Results Conclusion This paper (so far) • Credit tax/subsidy vs credit easing. • Direct credit provision is inefficient. • Subsidies are not inefficient but need to be financed. In the steady state and in response to shocks. Role of state contingent debt. • Raising more questions than providing answers • Model of liquidity. Exogeneity of financial shocks • Treating the symptoms and not the disease. 9 / 28
Introduction The literature The model Results Conclusion The environment Households Single household with workers and bankers. Infinitely lived. Share 1 − f of workers Share f of bankers Become workers with probability θ . Intermediate funds to firms. Can appropriate a fraction λ of bank assets. Need internal funds to be able to borrow. Firms Representative. Linear technology in labor. Borrows to pay for wage bill. Government Finances own consumption and credit subsidies with lump-sum (or distortionary) taxes and seigniorage. 10 / 28
Introduction The literature The model Results Conclusion Households • Problem: � � � ∞ χ 1 + φ N 1 + ϕ β t Max E 0 ln C t − , t 0 s.t. D t + E t Q t , t + 1 B t , t + 1 ≤ W t , where W t + 1 = B t , t + 1 + R t D t + Π b t + W t N t − P t C t − T t . 11 / 28
Introduction The literature The model Results Conclusion Firms • Linear technology: Y t = A t N t • Need to borrow nominal funds S t to pay the wage bill, W t N t ≤ S t • Receive subsidy on debt repayment, τ l t R l t S t . Profits: � � Π f 1 − τ l R l t = P t Y t − t W t N t , t 12 / 28
Introduction The literature The model Results Conclusion Bankers • Continuum j ∈ [ 0 , 1 ] . • Because of a costly enforcement problem, each bank must have internal funds, Z j , t . • Each bank borrows D j , t and lends S b j , t , S b j , t = D j , t + Z j , t • Because of exit, internal funds are scarce and remuneration is high. Internal funds are accumulated until exit. • Net worth evolves according to Z j , t + 1 = R l t S b j , t − R t D j , t 13 / 28
Introduction The literature The model Results Conclusion Bankers • Bankers maximize terminal wealth: � ∞ ( 1 − θ ) θ s Q t , t + 1 + s Z j , t + 1 + s V j , t = max E t s = 0 where �� � � R l S b Z j , t + 1 = t − R t j , t + R t Z j , t 14 / 28
Introduction The literature The model Results Conclusion Bankers • Costly enforcement problem: bankers can divert a fraction λ of assets S b j , t . • Incentive compatibility constraint: V j , t ≥ λ S b j , t 15 / 28
Introduction The literature The model Results Conclusion Bankers • The value V j , t can be written as V j , t = υ t S b j , t + η t Z j , t where � � � � S b j , t + 1 R l υ t = E t ( 1 − θ ) Q t , t + 1 t − R t + Q t , t + 1 θ υ t + 1 S b j , t � � ( 1 − θ ) + Q t , t + 1 θ Z j , t + 1 η t = E t η t + 1 . Z j , t 16 / 28
Introduction The literature The model Results Conclusion Bankers • Assuming ICC holds with equality S b η t j , t = ≡ φ t Z j , t λ − υ t where φ t is a measure of leverage. 17 / 28
Introduction The literature The model Results Conclusion Entry and exit of bankers • Exiting banks transfer net worth, ( 1 − θ ) Z t , to household. ω A fraction ( 1 − θ ) is given to newly entering bankers as start-up funds. • Internal funds of surviving bankers are θ Z t . • ξ t is a capital quality shock. • Aggregate net worth of bankers: �� � � R l Z t = ξ t ( θ + ω ) t − 1 − R t − 1 φ t − 1 + R t − 1 Z t − 1 . 18 / 28
Introduction The literature The model Results Conclusion The government • Credit policies: • Credit subsidies, τ l t R l t S t . • Direct intermediation, i.e. lending of a fraction ψ of S t at the market rate R l t . No incentive problem, but resource cost τ per unit of lending. • Direct enforcement cost? • Budget constraint: B g t + M t − ψ t S t R t − 1 B g t − 1 + M t − 1 + τ l t − 1 R l t − 1 S b ≤ t − 1 + τψ t − 1 S t − 1 − ψ t − 1 S t − 1 R l t − 1 + P t − 1 G t − 1 − T t − 1 19 / 28
Introduction The literature The model Results Conclusion Equilibria • Equilibria: conditions above for υ t and η t , and � � 1 − τ l R l − u C ( t ) t t u N ( t ) = A t u C ( t ) β u C ( t + 1 ) = R t E t P t P t + 1 � � φ t Z t A t N t = R l 1 − τ l t t 1 − ψ t P t η t φ t = λ − υ t �� � � R l t − 1 Z t = ξ t ( θ + ω ) R t − 1 − 1 φ t − 1 + 1 Z t − 1 R t − 1 S t C t + G t + τψ t = A t N t P t • The price level matters because Z t is predetermined. 20 / 28
Introduction The literature The model Results Conclusion Equivalence between credit subsidies and interest rates � � φ t , R l • Take an allocation, { C t , N t } and R t , η t , υ t t , where � � R l τ l t ≥ 1 but R t can be less than one. Take a path for . � � � � t � τ l � There is an alternative path and R t ≥ 1 such that t � � � � � R l 1 − τ l R l τ l 1 − � = t t t t � R l R l t t = � R t R t 21 / 28
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