M A -L L I , O I P R D E W O M O - S , O P D W P AC CR RO IN NK KA AG GE ES IL L RI IC CE ES S A AN ND D EF FL LA AT TI IO ON N OR RK KS SH HO OP J A 6– –9 9, , 20 00 09 9 J 6 2 AN NU UA AR RY Y Credit Frictions and Optimal Monetary Policy Vasco Curdia (FRB New York) Michael Woodford (Columbia University)
Credit Frictions and Optimal Monetary Policy Vasco C´ urdia Michael Woodford FRB New York Columbia University IMF Research Department Macro-Modeling Workshop C´ urdia and Woodford () Credit Frictions IMF January 2009 1 / 39
Motivation “New Keynesian” monetary models often abstract entirely from financial intermediation and hence from financial frictions C´ urdia and Woodford () Credit Frictions IMF January 2009 2 / 39
Motivation “New Keynesian” monetary models often abstract entirely from financial intermediation and hence from financial frictions Representative household Complete (frictionless) financial markets Single interest rate (which is also the policy rate) relevant for all decisions C´ urdia and Woodford () Credit Frictions IMF January 2009 2 / 39
Motivation “New Keynesian” monetary models often abstract entirely from financial intermediation and hence from financial frictions Representative household Complete (frictionless) financial markets Single interest rate (which is also the policy rate) relevant for all decisions But in actual economies (even financially sophisticated), there are different interest rates, that do not move perfectly together C´ urdia and Woodford () Credit Frictions IMF January 2009 2 / 39
% 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 Q4:1986 Q2:1987 Q4:1987 Q2:1988 Q4:1988 Q2:1989 Q4:1989 Q2:1990 Q4:1990 Q2:1991 Q4:1991 Q2:1992 Q4:1992 Q2:1993 Q4:1993 Q2:1994 Q4:1994 Prime Spread to FF Q2:1995 (Sources: FRB) Q4:1995 Q2:1996 Spreads Q4:1996 Q2:1997 Q4:1997 Q2:1998 Q4:1998 C&I Spread to FF Q2:1999 Q4:1999 Q2:2000 Q4:2000 Q2:2001 Q4:2001 Q2:2002 Q4:2002 Q2:2003 Q4:2003 Q2:2004 Q4:2004 Q2:2005 Q4:2005 Q2:2006 Q4:2006 Q2:2007 Q4:2007 Q2:2008 Q4:2008
basis points 100 120 140 160 180 200 220 240 260 280 300 320 340 360 380 20 40 60 80 0 01/04/05 03/04/05 05/04/05 07/04/05 09/04/05 11/04/05 01/04/06 03/04/06 05/04/06 USD LIBOR-OIS Spreads 07/04/06 (Source: Bloomberg) 09/04/06 1M 11/04/06 01/04/07 3M 03/04/07 6M 05/04/07 07/04/07 09/04/07 11/04/07 01/04/08 03/04/08 05/04/08 07/04/08 09/04/08 11/04/08
% 0 1 2 3 4 5 6 7 1/2/2007 2/2/2007 3/2/2007 4/2/2007 5/2/2007 6/2/2007 7/2/2007 (source: Bloomberg and Federal Reserve Board) 8/2/2007 9/2/2007 10/2/2007 LIBOR 1m vs FFR target 11/2/2007 LIBOR 1m 12/2/2007 1/2/2008 FFR target 2/2/2008 3/2/2008 4/2/2008 5/2/2008 6/2/2008 7/2/2008 8/2/2008 9/2/2008 10/2/2008 11/2/2008 12/2/2008
Motivation Questions: How much is monetary policy analysis changed by recognizing existence of spreads between different interest rates? How should policy respond to “financial shocks” that disrupt financial intermediation, dramatically widening spreads? C´ urdia and Woodford () Credit Frictions IMF January 2009 3 / 39
Motivation John Taylor (Feb. 2008) has proposed that “Taylor rule” for policy might reasonably be adjusted, lowering ff rate target by amount of increase in LIBOR-OIS spread — Essentially, Taylor rule would specify operating target for LIBOR rate rather than ff rate — Would imply automatic adjustment of ff rate in response to spread variations, as under current SNB policy C´ urdia and Woodford () Credit Frictions IMF January 2009 4 / 39
% 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 1/3/2007 2/3/2007 3/3/2007 4/3/2007 Repo O/N Index 5/3/2007 6/3/2007 7/3/2007 8/3/2007 LIBOR 3m 9/3/2007 10/3/2007 SNB Interest rates (source: SNB) 11/3/2007 LIBOR Target Lower Bound 12/3/2007 1/3/2008 2/3/2008 3/3/2008 4/3/2008 5/3/2008 LIBOR Target Upper Bound 6/3/2008 7/3/2008 8/3/2008 9/3/2008 10/3/2008 11/3/2008 12/3/2008
Motivation John Taylor (Feb. 2008) has proposed that “Taylor rule” for policy might reasonably be adjusted, lowering ff rate target by amount of increase in LIBOR-OIS spread — Essentially, Taylor rule would specify operating target for LIBOR rate rather than ff rate — Would imply automatic adjustment of ff rate in response to spread variations, as under current SNB policy Is a systematic response of that kind desirable? C´ urdia and Woodford () Credit Frictions IMF January 2009 5 / 39
The Model Generalizes basic (representative household) NK model to include C´ urdia and Woodford () Credit Frictions IMF January 2009 6 / 39
The Model Generalizes basic (representative household) NK model to include heterogeneity in spending opportunities costly financial intermediation C´ urdia and Woodford () Credit Frictions IMF January 2009 6 / 39
The Model Generalizes basic (representative household) NK model to include heterogeneity in spending opportunities costly financial intermediation Each household has a type τ t ( i ) ∈ { b , s } , determining preferences � 1 ∞ � � u τ t ( i ) ( c t ( i ) ; ξ t ) − 0 v τ t ( i ) ( h t ( j ; i ) ; ξ t ) dj ∑ β t E 0 , t = 0 C´ urdia and Woodford () Credit Frictions IMF January 2009 6 / 39
The Model Generalizes basic (representative household) NK model to include heterogeneity in spending opportunities costly financial intermediation Each household has a type τ t ( i ) ∈ { b , s } , determining preferences � 1 ∞ � � u τ t ( i ) ( c t ( i ) ; ξ t ) − 0 v τ t ( i ) ( h t ( j ; i ) ; ξ t ) dj ∑ β t E 0 , t = 0 Each period type remains same with probability δ < 1; when draw new type, always probability π τ of becoming type τ C´ urdia and Woodford () Credit Frictions IMF January 2009 6 / 39
The Model 5 4 3 u b c (c) − λ b 2 − λ s 1 u s c (c) 0 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 − − c c s b Marginal utilities of the two types C´ urdia and Woodford () Credit Frictions IMF January 2009 7 / 39
The Model Aggregation simplified by assuming intermittent access to an “insurance agency” C´ urdia and Woodford () Credit Frictions IMF January 2009 8 / 39
The Model Aggregation simplified by assuming intermittent access to an “insurance agency” State-contingent contracts enforceable only on those occasions Other times, can borrow or lend only through intermediaries, at a one-period, riskless nominal rate, different for savers and borrowers C´ urdia and Woodford () Credit Frictions IMF January 2009 8 / 39
The Model Aggregation simplified by assuming intermittent access to an “insurance agency” State-contingent contracts enforceable only on those occasions Other times, can borrow or lend only through intermediaries, at a one-period, riskless nominal rate, different for savers and borrowers Consequence: long-run marginal utility of income same for all households, regardless of history of spending opportunities C´ urdia and Woodford () Credit Frictions IMF January 2009 8 / 39
The Model Aggregation simplified by assuming intermittent access to an “insurance agency” State-contingent contracts enforceable only on those occasions Other times, can borrow or lend only through intermediaries, at a one-period, riskless nominal rate, different for savers and borrowers Consequence: long-run marginal utility of income same for all households, regardless of history of spending opportunities MUI and expenditure same each period for all households of a given type: hence only increase state variables from 1 to 2 C´ urdia and Woodford () Credit Frictions IMF January 2009 8 / 39
The Model Euler equation for each type τ ∈ { b , s } : � 1 + i τ � λ τ t [ δλ τ t = β E t t + 1 + ( 1 − δ ) λ t + 1 ] Π t + 1 where λ t ≡ π b λ b t + π s λ s t C´ urdia and Woodford () Credit Frictions IMF January 2009 9 / 39
The Model Euler equation for each type τ ∈ { b , s } : � 1 + i τ � λ τ t [ δλ τ t = β E t t + 1 + ( 1 − δ ) λ t + 1 ] Π t + 1 where λ t ≡ π b λ b t + π s λ s t Aggregate demand relation: Y t = ∑ π τ c τ ( λ τ t ; ξ t ) + G t + Ξ t τ where Ξ t denotes resources used in intermediation C´ urdia and Woodford () Credit Frictions IMF January 2009 9 / 39
Log-Linear Equations Intertemporal IS relation: Y t = E t ˆ ˆ ı avg − π t + 1 ] − E t [ ∆ g t + 1 + ∆ ˆ Y t + 1 − ¯ σ [ ˆ Ξ t + 1 ] t σ s Ω ˆ σ ( s Ω + ψ Ω ) E t ˆ − ¯ Ω t + ¯ Ω t + 1 , where ı avg ı b ı d ˆ ≡ π b ˆ t + π s ˆ t , t Ω t ≡ ˆ t − ˆ ˆ λ b λ s t , g t is a composite exogenous disturbance to expenditure of type b , type s , and government, σ ≡ π b s b σ b + π s s s σ s > 0, ¯ and s Ω , ψ Ω depend on asymmetry C´ urdia and Woodford () Credit Frictions IMF January 2009 10 / 39
Log-Linear Equations Determination of the marginal-utility gap: ˆ ω t + ˆ δ E t ˆ Ω t = ˆ Ω t + 1 , where ˆ δ < 1 and ı b ı d ω t ≡ ˆ t − ˆ ˆ t measures deviation of the credit spread from its steady-state value C´ urdia and Woodford () Credit Frictions IMF January 2009 11 / 39
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