Essays in Monetary and Financial Economics

This thesis consists of four chapters that contribute to the fields of monetary and financial economics. The second chapter is based on joint work with Lucas Radke and studies the interaction between monetary policy and expectations when individuals’ expectations depend on their lifetime experiences. Since expectations differ across age-groups, the demographic structure is a relevant determinant for aggregate expectations. We show that monetary policy’s influence on inflation via expectations is impaired if the heterogeneity in expectations is part of the model. Key to this result is that agents’ limited experience leads them to expect a less persistent impact of monetary policy. In younger societies, that consist of less experienced agents, this effect is more pronounced and monetary policy is less powerful in line with empirical evidence. A demographic shift towards an older economy affects aggregate expectations such that inflation volatility rises. However, the monetary policy trade-off between output and inflation stabilization attenuates. The third chapter is based on joint work with Matthias Kaldorf and investigates the impact of central bank collateral frameworks on the firm-side. When debt of non-financial firms allows banks to obtain liquidity from the central bank, a premium is paid on these assets. As a first contribution we show that heterogeneity with respect to firm profitability shapes how firms’ debt choice reacts to this premium. Moreover, firm reactions feed back on the supply and riskiness of collateral following collateral easing. As a second contribution, we illustrate this mechanism in a more elaborated model of firms. Firm responses substantially dampen the increase in collateral supply after a collateral easing. Key to this result is increased firm risk-taking that lowers the value of collateral. We show how a covenant, that conditions eligibility on current leverage, ameliorates this dampening effect. The fourth chapter is based on joint work with Francesco Giovanardi, Matthias Kaldorf, and Lucas Radke. It builds on the analysis of Chapter 3 to investigate the preferential treatment of green bonds in central bank collateral frameworks. We show that although preferential treatment has beneficial effects on the environment, it has significant negative side-effects in terms of higher firm risk that weakens the policy’s pass-through on sustainable investment. Preferential treatment further disturbs the original trade-off of central bank collateral policy between the vailability and riskiness of collateral. We show that a carbon tax is a more powerful tool to address the negative externality from pollution. However, such a policy is optimally accompanied by changes in the central bank collateral framework that reduce a carbon tax’s negative impact on the supply of collateral. The final chapter is based on joint work with Christoph Kaufmann and Giovanni di Iasio and investigates the liquidity regulation of investment funds. Investment funds hold insufficient liquid assets to cater to periodic household redemptions, since they fail to internalize the impact of their portfolio choice on bond prices. This lowers welfare due to resource losses and a reduction in investment fund financial intermediation. We show that a macroprudential liquidity buffer for investment funds increases welfare. However, it is associated with smaller household holdings of the liquid asset, which constitutes the main welfare downside. At its optimal level, the regulatory liquidity buffer exceeds the voluntary investment fund buffer by a factor of four. In case of an aggregate shock that induces a loss of funding for investment funds, the optimal buffer prevents an amplification of the initial funding loss that would severely reduce output and consumption

Experience-Based Heterogeneity in Expectations and Monetary Policy

The present paper studies the effect of monetary policy on inflation and output within a New Keynesian model with Experience-Based Learning (EBL) that renders expectations heterogeneous across age groups. Under EBL, the age-distribution directly affects the composition of aggregate expectations which gives rise to a novel channel by which the demographic structure of an economy affects monetary policy: the Experience Channel. Relative to models with homogeneous and age-independent expectations, we show that EBL weakens the pass-through of monetary policy on aggregate demand. This affects monetary policy transmission in two ways. First, the impact response of inflation and output to monetary policy shocks is less pronounced since the response of expectations under EBL is muted. Second, the response of inflation is more persistent, since the interest rate sensitivity of aggregate demand is weaker. Moreover, EBL changes the classical monetary policy trade-off between output and inflation stabilisation under supply shocks relative to models with ageindependent expectations. First, for a given inflation volatility, output is always less volatile due to the reduced sensitivity of expectations to monetary policy. Second, under EBL, the trade-off becomes more severe in ageing economies. We show that this effect is largely driven by the Experience Channel

How do central bank collateral frameworks affect non-financial firms?

Central banks implement monetary policy by extending credit to banks, for example via standing facilities or long-term refinancing operations. In addition to setting policy rates, central banks also specify in their collateral framework which financial assets banks can pledge to obtain central bank funding. Here we discuss the design of collateral frameworks for the case of corporate sector assets. This is particularly relevant in countries where the supply of safe government bonds is insufficient to satiate collateral demand

Risky financial collateral, firm heterogeneity, and the impact of eligibility requirements

This paper studies the effects of making corporate sector assets eligible as collateral for central bank borrowing. Banks are willing to pay collateral premia on assets if they become eligible as collateral. Collateral premia make debt financing cheaper for eligible firms, which respond by increasing their debt issuance. While this has a positive effect on collateral supply, firm responses also have a negative effect: higher debt issuance makes corporate bonds riskier in future periods, which in turn reduces aggregate collateral. We provide a novel analytical characterization of firm responses to eligibility requirements in a heterogeneous firm model with default risk and collateral premia paid on eligible bonds. Using a calibration of the model to euro area data, we study the impact of the ECB's col-lateral easing policy during the 2008 financial crisis and evaluate the quantitative relevance of firm responses. We find that firm responses substantially deteriorate collateral quality and dampen the total increase of collateral supply. Our analysis suggests that a covenant conditioning eligibility on leverage and current default risk is a potentially powerful in-strument to mitigate the adverse impact of collateral premia on default risk and, thereby, to maintain a high level of collateral supply

Risky Financial Collateral, Firm Heterogeneity, and the Impact of Eligibility Requirements

We study the eligibility of corporate bonds as collateral for central bank operations and its effect on interbank and corporate bond markets. While money market functionality increases in the amount of eligible assets, a thorough assessment of collateral policies must also account for endogenous responses of the corporate sector: banks increase demand for corporate bonds if they are eligible as collateral, and firms increase their leverage and default risk in response. This has adverse effects on the money market due to costs associated with deteriorating collateral quality. To jointly analyze the dynamics of collateral supply and collateral quality, we construct a heterogeneous firm model with defaultable bonds which banks use to collateralize money market borrowing. In this setting, eligible firms pay lower spreads and have higher leverage, consistent with empirical evidence. The central bank faces a trade-off between fostering collateral supply and increased risk-taking on the corporate bond market, which deteriorates collateral quality in equilibrium. Calibrating the model to Euro Area data, we find that reducing eligibility requirements from A- to BBB- increases collateral supply by 33%, while collateral default risk increases by 53%. Under an adverse shock to firm fundamentals, these numbers increase to 32% and 63%, i.e. collateral quality deteriorates disproportionately. Ultimately, firm fundamentals place restrictions on the efficacy of central bank collateral policy

Macroprudential regulation of investment funds

The investment fund sector, the largest component of the non-bank financial system, is growing rapidly and the economy is becoming more reliant on investment fund financial intermediation. This paper builds a dynamic stochastic general equilibrium model with banks and investment funds. Banks grant loans and issue liquid deposits, which are valuable to households. Funds invest in corporate bonds and may hold liquidity in the form of bank deposits to meet investor redemption requests. Without regulation, funds hold insufficient deposits and must sell bonds when hit by large redemptions. Bond liquidation is costly and eventually reduces investment funds' intermediation capacity. Even when accounting for side effects due to a reduction of deposits held by households, a macroprudential liquidity requirement improves welfare by reducing bond liquidation and by increasing the economy's resilience to financial shocks akin to March 2020

The preferential treatment of green bonds

We study the preferential treatment of green bonds in the central bank collateral framework as an environmental policy instrument within a DSGE model with environmental and financial frictions. In the model, green and carbon-emitting conventional firms issue defaultable corporate bonds to banks that use them as collateral. The collateral premium associated to a relaxation in collateral policy induces firms to increase bond issuance, investment, leverage, and default risk. Collateral policy solves a trade-off between increasing collateral supply, adverse effects on firm risk-taking, and subsidizing green investment. Optimal collateral policy is characterized by modest preferential treatment, which increases the green investment share and reduces emissions. However, welfare gains fall well short of what can be achieved with optimal emission taxes. Moreover, due to elevated risk-taking of green firms, preferential treatment is a qualitatively imperfect substitute of Pigouvian taxation on emissions: if and only if the optimal emission tax can not be implemented, optimal collateral policy features preferential treatment of green bonds