Gradualism vs Cold Turkey

The paper analyzes the incentive for the ECB to establish reputation by pursuing a restrictive policy right at the start of its operation. The bank is modelled as risk averse with respect to deviations of both inflation and output from her target. The public, being imperfectly informed about the bank’s preferences uses observed inflation as (imperfect) signal for the unknown preferences. Under linear learning rules - which are commonly used in the literature - a gradual build up of reputation is the optimal response. The paper shows that such a linear learning rule is not consistent with efficient signaling. It is shown that in a game with efficient signaling, a cold turkey approach - allowing for deflation - is optimal for a strong bank - accepting high current output losses at the beginning in order to demonstrate its toughness.Die Arbeit untersucht die Anreize der Europäischen Zentralbank, in der Startphase durch restriktive Politik Reputation aufzubauen. Die Öffentlichkeit kennt die Präferenzen der Zentralbank nicht; sie verwendet die beobachtete Inflationsrate als (imperfektes) Signal. Wird eine lineare Lernregel unterstellt - der Standardfall in der Literatur - erweist es sich als optimal, hohe Inflationserwartungen zumindest teilweise zu akkommodieren und so Reputation nur schrittweise aufzubauen. Die Arbeit zeigt aber, daß eine solche lineare Lernregel mit effizientem Signalverhalten nicht konsistent ist. Bei effizientem Signalisieren kann es für eine harte Zentralbank optimal sein, in der Startphase durch eine sehr restriktive, deflationäre Politik ihre Präferenzen zu offenbaren

Gradualism vs Cold Turkey : how to establish credibility for the ECB

The paper analyzes the incentive for the ECB to establish reputation by pursuing a restrictive policy right at the start of its operation. The bank is modelled as risk averse with respect to deviations of both inflation and output from her target. The public, being imperfectly informed about the bank’s preferences uses observed inflation as (imperfect) signal for the unknown preferences. Under linear learning rules - which are commonly used in the literature - a gradual build up of reputation is the optimal response. The paper shows that such a linear learning rule is not consistent with efficient signaling. It is shown that in a game with efficient signaling, a cold turkey approach - allowing for deflation - is optimal for a strong bank - accepting high current output losses at the beginning in order to demonstrate its toughness. JEL classification: D 82, E 58Die Arbeit untersucht die Anreize der Europäischen Zentralbank, in der Startphase durch restriktive Politik Reputation aufzubauen. Die Öffentlichkeit kennt die Präferenzen der Zentralbank nicht; sie verwendet die beobachtete Inflationsrate als (imperfektes) Signal. Wird eine lineare Lernregel unterstellt - der Standardfall in der Literatur - erweist es sich als optimal, hohe Inflationserwartungen zumindest teilweise zu akkommodieren und so Reputation nur schrittweise aufzubauen. Die Arbeit zeigt aber, daß eine solche lineare Lernregel mit effizientem Signalverhalten nicht konsistent ist. Bei effizientem Signalisieren kann es für eine harte Zentralbank optimal sein, in der Startphase durch eine sehr restriktive, deflationäre Politik ihre Präferenzen zu offenbaren. JEL classification: D 82, E 5

Bailing in the private sector : on the adequate design of international bond contracts

During the last decade, there has been a significant bias towards bond financing on emerging markets, with private investors relying on a bail-out of bonds by the international community. The bias has been a main cause for recent excessive fragility of international capital markets. The paper shows how collective action clauses in bonds contracts help to involve the private sector in risk sharing. It argues that such clauses, as a market based instrument, will raise spreads for emerging market debt and so help to correct a market failure towards excessive bond finance. Recent pressure by the IMF to involve the private sector is facing a conflict between the principle to honour existing contracts and the principle of equal treatment of bondholders

Financial Stability and Monetary Policy - A Framework

The paper presents a stylised framework to analyse conditions under which monetary policy contributes to amplified movements in the housing market. Extending work by Hyun Shin (2005), the paper analyses self enforcing feedback mechanisms resulting in amplifier effects in a credit constrained economy. The paper characterizes conditions for asymmetric effects, causing systemic crises. By injecting liquidity, monetary policy can prevent a meltdown. Anticipating such a response, private agents are encouraged to take higher risks. Provision of liquidity works as a public good, but it may create potential conflicts with other policy objectives and may give incentives to build up leverage with a high systemic exposure to small probability events

Financial Stability and Monetary Policy – A Framework

The paper presents a stylised framework to analyse conditions under which monetary policy contributes to amplified movements in the housing market. Extending work by Hyun Shin (2005), the paper analyses self enforcing feedback mechanisms resulting in amplifier effects in a credit constrained economy. The paper characterizes conditions for asymmetric effects, causing systemic crises. By injecting liquidity, monetary policy can prevent a meltdown. Anticipating such a response, private agents are encouraged to take higher risks. Provision of liquidity works as a public good, but it may create potential conflicts with other policy objectives and may give incentives to build up leverage with a high systemic exposure to small probability events.

Endogenous Systemic Liquidity Risk

Traditionally, aggregate liquidity shocks are modelled as exogenous events. Extending our previous work (Cao & Illing, 2007), this paper analyses the adequate policy response to endogenous systemic liquidity risk. We analyse the feedback between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante are a crucial requirement for sensible lender of last resort policy. In addition, we analyse the impact of equity requirements and narrow banking, in the sense that banks are required to hold sufficient liquid funds so as to pay out in all contingencies. We show that such a policy is strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy

Speculative Attacks

Models with multiple equilibria are a popular way to explain currency attacks. Morris and Shin (1998) have shown that, in the context of those models, unique equilibria may prevail once noisy private information is introduced. In this paper, we generalize the results of Morris and Shin to a broader class of probability distributions and show - using the technique of iterated elimination of dominated strategies - that uniqueness will hold, even if we allow for sunspots and individual uncertainty about strategic behavior of other agents. We provide a clear exposition of the logic of this model and we analyse the impact of transparency on the probability of a speculative attack. For the case of uniform distribution of noisy signals, we show that increased transparency of government policy reduces the likelihood of attacks

Speculative attacks : unique sunspot equilibrium and transparency

Models with multiple equilibria are a popular way to explain currency attacks. Morris and Shin (1998) have shown that, in the context of those models, unique equilibria may prevail once noisy private information is introduced. In this paper, we generalize the results of Morris and Shin to a broader class of probability distributions and show - using the technique of iterated elimination of dominated strategies - that uniqueness will hold, even if we allow for sunspots and individual uncertainty about strategic behavior of other agents. We provide a clear exposition of the logic of this model and we analyse the impact of transparency on the probability of a speculative attack. For the case of uniform distribution of noisy signals, we show that increased transparency of government policy reduces the likelihood of attacks. JEL Classification F 31, D 82Modelle mit multiplen Gleichgewichten sind ein populärer Ansatz zur Erklärung spekulativer Attacken. Morris und Shin (1998) haben jedoch gezeigt, dass auch im Rahmen dieser Modelle eindeutige Gleichgewichte zu erwarten sind, sobald die Spekulanten verzerrte private Signale über die Fundamentaldaten erhalten. In dieser Arbeit verallgemeinern wir die Ergebnisse von Morris und Shin und zeigen, dass die Gleichgewichte selbst dann eindeutig sind, wenn Sunspot Variablen und individuelle Unsicherheit über Strategien zugelassen werden. Zudem analysieren wir, welchen Einfluss Transparenz auf die Wahrscheinlichkeit erfolgreicher Attacken hat. Für den Fall der Gleichverteilung verzerrter Signale zeigen wir, dass bei transparenter Geldpolitik ein Ausbruch solcher Attacken mit geringerer Wahrscheinlichkeit auftritt

Liquidity Shortages and Monetary Policy

The paper models the interaction between risk taking in the financial sector and central bank policy. It shows that in the absence of central bank intervention, the incentive of financial intermediaries to free ride on liquidity in good states may result in excessively low liquidity in bad states. In the prevailing mixed-strategy equilibrium, depositors are worse off than if banks would coordinate on more liquid investment. It is shown that public provision of liquidity improves the allocation, even though it encourages more risk taking (less liquid investment) by private banks