Credit risk transfers and the macroeconomy : [This Draft: September 2010]

The recent financial crisis has highlighted the limits of the “originate to distribute” model of banking, but its nexus with the macroeconomy and monetary policy remains unexplored. I build a DSGE model with banks (along the lines of Holmström and Tirole [28] and Parlour and Plantin [39] and examine its properties with and without active secondary markets for credit risk transfer. The possibility of transferring credit reduces the impact of liquidity shocks on bank balance sheets, but also reduces the bank incentive to monitor. As a result, secondary markets allow to release bank capital and exacerbate the effect of productivity and other macroeconomic shocks on output and inflation. By offering a possibility of capital recycling and by reducing bank monitoring, secondary credit markets in general equilibrium allow banks to take on more risk. Keywords: Credit Risk Transfer , Dual Moral Hazard , Monetary Policy , Liquidity , Welfare JEL Classification: E3, E5, G3 First Draft: December 2009, This Draft: September 201

Monetary policy in a world with different financial systems

Major currency areas are characterized by important differences in financial structure that are clear in microeconomic data. Surprisingly, this fact is seldom discussed in the analysis of the international transmission of shocks. This paper attempts to fill the gap. First, I show some stylized facts about financial differences and cyclical correlations among the main OECD countries. Second, using a two-country model with monopolistic competition and sticky prices, calibrated to US and euro area data, I analyze the international transmission of shocks with different degrees of financial fragility in the two economies. I find, first, that financial diversity can account for heterogenous business cycle fluctuations. Differential responses to shocks are shown to occur with independent monetary policies - Taylor rules or rigid inflation targets - even with low degrees of economic and financial openness. Credible pegs help to increase the synchronization of cycles. Secondly, differences in persistence of the interest rates help to explain high persistence in the real exchange rate. Finally, weak financial systems can result in large welfare losses under symmetric and correlated shocks. JEL Classification: E3, E42, E44, E52, F41differential transmission mechanism, Financial diversity, financial stability, monetary regimes, welfare losses

Stabilization policy in a two country model and the role of financial frictions

This paper studies the optimal choice of exchange rate regimes between two large currency areas. It provides a positive and normative analysis of alternative monetary policy rules in a model with sticky prices, monopolistic competition, and frictions in the processes of capital accumulation and acquisition of external finance. The stabilization and welfare analysis provides a sound result on the desirability of monetary policy and exchange rate flexibility as business cycle smoothing devices. Given the presence of financial frictions the paper gives a richer explanation of the mechanism behind the stabilization properties of floating exchange rates and explains the difference in sign of the international transmission of shocks compared to the model without capital. In a two country model without capital the pattern of output is mainly determined by the pattern of consumption: any movement in the exchange rate under floating exchange rates causes movements in the price of the international traded bond and in consumption and consequently in output. In the model with capital and financial frictions output mimics the movements in investment: an active monetary authority reacting to exchange rate movements generates perverse movements in the interest rate, destabilizing investment and output. The paper also suggests how monetary policy can improve financial stability, stressing the importance of the interest rate smoothing in tuning movements in investment and output and in reducing the welfare cost of financial frictions mostly under fixed exchange rates. JEL Classification: E3, E42, E44, E52, F41Fiancial frictions, financial stability, monetary regimes, stabilization policy

Optimal monetary policy rules with labor market frictions

This paper studies optimal monetary policy rules in a framework with sticky prices, matching frictions and real wage rigidities. Optimal monetary policy is given by a constrained Ramsey plan in which the monetary authority maximizes the agents’ welfare subject to the competitive economy relations and the assumed monetary policy rule. I find that optimal policy should deviate from the strict inflation targeting since the policy maker faces a typical unemployment/inflation trade-off. In this context and unlike a standard New Keynesian model stabilizing inflation is not sufficient to stabilize the marginal cost (hence the output gap) since the latter also depends on the evolution of unemployment. The matching frictions add a congestion externality since the number of unemployed in the market and their bargaining power reduce the probability of forming matches. Hence optimal monetary policy features unemployment targeting along with inflation targeting. JEL Classification: E52, E24matching frictions, optimal monetary policy rules, wage rigidity

Ramsey monetary policy with labour market frictions

This paper studies the design of optimal monetary policy (in terms of unconstrained Ramsey allocation) in a framework with sticky prices and matching frictions. Furthermore I consider the role of real wage rigidities. Optimal policy features significant deviations from price stability in response to various shocks. This is so since search externalities generate an unemployment/inflation trade-off. In response to productivity shocks optimal policy is pro-cyclical when the worker’s bargaining power is higher than the share of unemployed people in the matching technology and viceversa. This is so since when the workers’ share of surplus is high there are many searching workers and few vacancies hence the monetary authority has an incentive to increase vacancy profitability by reducing the interest rate and increasing inflation. The opposite is true when the workers’ share of surplus is high. This implies that optimal inflation volatility is U-shaped with respect to workers’ bargaining power. JEL Classification: E52, E24matching frictions, optimal monetary policy, wage rigidity

Ramsey monetary policy and international relative prices

We analyze welfare maximizing monetary policy in a dynamic two-country model with price stickiness and imperfect competition. In this context, a typical terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in an economy that evolves around a steady-state which is not necessarily efficient. Second, it allows to describe a full range of alternative dynamic equilibria when price setters in both countries are completely forward-looking and households' preferences are not restricted. In this context, we study optimal policy both in the long-run and along a dynamic path, and we compare optimal commitment policy under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation. Klassifikation: E52, F41 . This version: January, 2004. First draft: October 2003

Trust in the monetary authority : [draft: july 2013]

The efficacy of monetary authority actions depends primarily on the ability of the monetary authority to affect inflation expectations, which ultimately depend on agents' trust. We propose a model embedding trust cycles, as emerging from sequential coordination games between atomistic agents and the policy maker, in a monetary model. Trust affects agents' stochastic discount factor, namely the price of future risk, and their expectation formation process: these effects in turn interact with the monetary transmission mechanism. Using data from the Eurobarometer survey we analyze the link between trust on the one side and the transmission mechanism of shocks and of the policy rate on the other: data show that the two interact significantly and in a way comparable to the obtained in our model

Ramsey monetary policy and international relative prices

We analyze welfare maximizing monetary policy in a dynamic two-country model with price stickiness and imperfect competition. In this context, a typical terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in an economy that evolves around a steady-state which is not necessarily efficient. Second, it allows to describe a full range of alternative dynamic equilibria when price setters in both countries are completely forwardlooking and households’ preferences are not restricted. In this context, we study optimal policy both in the long-run and along a dynamic path, and we compare optimal commitment policy under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation. JEL Classification: E52, F41Cooperation, imperfect competition, Nash equilibrium, optimal monetary policy, Ramsey planner, sticky prices

Optimal Interest Rate Rules, Asset Prices and Credit Frictions

We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the "financial markup" (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behavior of inflation relative to its credit-frictionless level. Thus neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy

Unions Power, Collective Bargaining and Optimal Monetary Policy

We study Ramsey policies and optimal monetary policy rules in a model with sticky prices and unionized labour markets. Collective wage bargaining and unions monopoly power dampen wage fluctuations and amplify employment fluctuations relatively to a DNK model. The optimal monetary policy must trade-off between stabilizing inflation and reducing inefficient unemployment fluctuations induced by unions' monopoly power. In this context the monetary authority uses inflation as a tax on unions' rents. The optimal monetary policy rule targets unemployment alongside inflation.