Unconventional Monetary Policy

Unconventional Monetary Policy Mark Gertler (based on joint work with Peter Karadi) NYU October 29

Old Macro Analyzes pre versus post 1984:Q4. 1

New Macro Analyzes pre versus post August 27 Post August 27: EndoftheGreatModeration Financial Crisis Unconventional Monetary Policy 2

.4 Real GDP growth.3.2.1.1.2.3 1975 198 1985 199 1995 2 25

Figure 1: Selected Corporate Bond Spreads Basis points Quarterly NBER Q4. Peak Avg. Senior Unsecured Medium-Risk Long-Maturity Baa 8 6 4 2 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 21 23 25 27 Note: The black line depicts the average credit spread for our sample of 5,269 senior unsecured corporate bonds; the red line depicts the average credit spread associated with very long maturity corporate bonds issued by firms with low to medium probability of default (see text for details); and the blue line depicts the standard Baa credit spread, measured relative to the 1-year Treasury yield. The shaded vertical bars denote NBER-dated recessions.

1.2 5.1 5 real GDP growth (right) lending standards (left).1 1 199 1992 1994 1996 1998 2 22 24 26 28.2

Unconventional vs. Conventional Monetary Policy Conventional: The central bank adjusts the short term rate to affect the market structure of interest rates. Unconventional: The central bank lends directly in private credit markets. Section 13.3 of the Federal Reserve Act: "In unusual and exigent circumstances.. the Federal Reserve may lend directly to private borrowers to the extent it judges the loans to be adequately secured." 3

Federal Reserve Assets Trillions of Dollars 3 2.5 2 1.5 1 Repo Treasury Securities Other AMLF Maiden Lane I, II, III Other Credit (&AIG ext) PDCF, Other Broker-dealer TAF Primary Credit Currency Swaps Agency MBS Agency Debt TALF CPFF 3 2.5 2 1.5 1 Trillions of Dollars.5.5 Aug-7 Oct-7 Dec-7 Feb-8 Apr-8 Jun-8 Aug-8 Oct-8 Dec-8 Feb-9 Apr-9 Federal Reserve Liabilities 2.5 Treasury, SFA 2.5 2 1.5 1 Reserve Balances Treasury, ga Reverse Repo Other Currency 2 1.5 1.5 Source: H41, Bloomberg Aug-7 Oct-7 Dec-7 Feb-8 Apr-8 Jun-8 Aug-8 Oct-8 Dec-8 Feb-9 Apr-9.5

Liquidity Facilities CPFF and Commercial Paper Outstanding Billions of Dollars 1,9 1,8 1,7 Total (left axis) Source: Federal Reserve Board, Haver, FDIC Federal Reserve Net Holdings (right axis) Billions of Dollars Mar 31: 336.3 1,6 Apr 17: FDIC 235.8 TLGP 1,5 (right axis) Apr 17: 1,4 1473.7 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 5 4 3 2 1 3-month CP Rates over OIS Basis Points 7 6 5 4 3 2 1 AA Financial Apr 17: A2/P2/F2 143. Non-Financial Apr 17: 61. Apr 17: 27. AA Asset-Backed ABCP CPFF Fee AA Non-Financial Unsecured CPFF Fee -1 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Source: Federal Reserve Board, Haver, Bloomberg Apr 17: 6. Basis Points 7 6 5 4 3 2 1-1 TSLF Schedule 1 & 2 Total Outstanding Overnight Financing Spreads Billions of Dollars 15 Billions of Dollars 15 Basis Points 25 Basis Points 25 1 Schedule 2 Apr 15: 2.6 1 2 15 Agency MBS Agency Debt 2 15 5 Schedule 1 Apr 16:. 5 1 5 Apr 17: 8. Apr 17:. 1 5 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Source: Federal Reserve Board -5-5 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Note: Spreads are between overnight agency debt and Source: Bloomberg MBS and Treasury general collateral repo rates Agency MBS Transactions Agency MBS to Average 5y and 1y Yields Billions of Dollars 3 2 Outright Purchases Apr 15: 287.2 Billions of Dollars 3 2 Basis Points 3 25 Fannie Mae Basis Points 25 2 1 Temporary OMO Accepted Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Source: Federal Reserve Board, Haver Apr 17:. 1 2 Apr 17: 176.4 15 1 Mar-8 Jun-8 Sep-8 Dec-8 Mar-9 Note: Spreads are agency 3 year on-the-run Source: FRB, Haver, Bloomberg coupon to average of 5 and 1 year yields 15

Issues Current crisis has featured a disruption of financial intermediation. The Fed has used unconventionary monetary policy to combat it: However, existing quantitative models not adequate: Baseline models (Christiano/Eichenbaum/Evans, Smets/Wouters) have frictionless capital markets Models with financial frictions (Bernanke/Gertler/Gilchrist, Christiano, Motto, Rostagno) consider frictions on non-financial firms and do not model credit policy. 4

What We Do Develop a quantitative monetary DSGE model that allows for financial intermediaries that face endogenous balance sheet constraints. Use the model to simulate a crisis that has some of the features of the current downturn. Assess how unconventional monetary policy (direct central bank intermediation.) could moderate the downturn. Compute the optimal "uncoventional" response to the downturn and the welfare gains. 5

Model Monetary DSGE with Balance-Sheet Constrained Financial Intermediaries Agents Households Financial Intermediaries (face financial constraints) Intermediate Goods Producer Capital Producers Monopolistically competitve retailers (set nominal prices on a staggered basis) Central Bank 6

Households Within each household, 1 f "workers" and f "bankers". Workers supply labor and return their wages to the household. Each banker manages a financial intermediary and also transfers earnings back to household. Perfect consumption insurance within the family. 7

Households (con t) To limit bankers ability to save to overcome financial constraints: With i.i.d prob. 1 θ, a banker exits next period. (average survival time = 1 1 θ ) Upon exiting, a banker transfers retained earnings to the household and becomes a worker. Each period, (1 θ)f workers randomly become bankers, keeping the number in each occupation constant Each new banker receives a "start up" transfer from the family. 8

Households (con t) X max E t β i [ln(c t+i hc t+i 1 ) i= χ 1+ϕ L1+ϕ t+i ] s.t. C t = W t L t + Π t + T t + R t B t B t+1 B t short term debt (intermediary deposits and government debt) Π t payouts to the household from firm ownership net the transfer it gives to its new bankers. 9

Financial Intermediaries Intermediary Balance Sheet Evolution of Net Worth Q t S jt = N jt + B jt N jt+1 = R kt+1 Q t S jt R t+1 B jt = (R kt+1 R t+1 )Q t S jt + R t+1 N jt 1

Financial Intermediaries (con t) X V jt = maxe t (1 θ)θ i β i Λ t,t+1+i (N jt+1+i ) i X = maxe t (1 θ)θ i β i Λ t,t+1+i [(R kt+1+i R t+1+i )Q t+i S jt+i i With Frictionless Capital Markets: E t βλ t,t+1+i (R kt+1+i R t+1+i )= With Capital Market Frictions: E t βλ t,t+1+i (R kt+1+i R t+1+i ) + R t+1+i N jt+i ] 11

Financial Intermediaries (con t) Agency Problem: After the banker/intermediary borrows funds at the end of period t, it may divert the fraction λ of total assets back to its family. If the intermediary does not honor its debt, depositers can liquidate the intermediate and obtain the fraction 1 λ of initial assets Incentive Constraint: V jt λq t S jt 12

Financial Intermediaries (con t) Simplifying V jt : V jt = v t Q t S jt + η t N jt v t = E t {(1 θ)βλ t,t+1 (R kt+1 R t+1 )+βλ t,t+1 θx t,t+1 v t+1 } η t = E t {(1 θ)+βλ t,t+1 θz t,t+1 η t+1 } with x t,t+i Q t+i S jt+i /Q t S jt,z t,t+i N jt+i /N jt. 13

Financial Intermediaries (con t) The incentive constraint becomes: When constraint binds: v t Q t S jt + η t N jt λq t S jt Q t S j t = η t N jt λ v t = φ t N jt where φ t is the intermediaries "leverage" ratio. 14

Financial Intermediaries (con t) Since the leverage ratio φ t does not depend on firm-specific factors, we can aggregate: Q t S pt = φ t N t where: Q t S pt total assets privately intermediated N t total intermediary capital 15

Credit Policy Central bank intermediation supplements private intermediation: Q t S t = Q t S pt + Q t S gt The central bank issues government debt that pays R t+1 and then lends to nonfinancial firms at R kt+1. Efficiency cost of τ per unit of gov t credit provided. Unlike private intermediaries, the central bank is not "balance-sheet" constrained. 16

Credit Policy (con t) Q t S gt = ψ t Q t S t = Q t S t = Q t S pt + Q t S gt = φ t N t + ψ t Q t S t = Q t S t = 1 1 ψ t φ t N t Q t S t is increasing in the intensity of credit policy, as measured by ψ t. 17

Evolution of Net Worth N t = N et + N nt N et = θ[(r kt R t )φ t + R t ]N t 1 N nt = 1 θ (1 θ)q ts t 1 N t = θ[(r kt R t )φ t + R]N t 1 + Q t S t 1 18

Intermediate Goods Firms At the end of period t, an intermediate goods producer acquires capital K t+1 for use in t +1 No adjustment costs and no financing frictions The firm finances K t+1 by obtaining funds from intermediaries. It issues S t state-contingent claims (equity) equal to the number of units of capital acquired K t+1 and prices each claim at the price of a unit of capital Q t : Q t K t+1 = Q t S t 19

Intermediate Goods Firms (con t) Production Y t = A t (U t ξ t K t ) α L 1 α t where U t is capital utilization, ξ t K t is effective capital and ξ t is a shock to "capital quality": Evolution of Firm Capital: K t+1 = I t +(1 δ(u t )ξ t K t 2

Intermediate Goods Firms (con t) F.O.N.C. P mt+1 α Y t+1 U t+1 = δ (U t+1 ) P mt+1 α Y t+1 L t+1 = W t+1 Payout to Capital R kt+1 = [P mt+1α Y t+1 K t+1 + Q t+1 δ(u t+1 )]ξ t+1 Q t 21

Capital Producing Firms Produce new capital to sell to the market, subject to adjustment costs on the rate of net investment. Q t relation for investment: Q t =1+f à Int I nt 1! + I nt f ( I nt 1 I n I nt 1 ) E t Λ t,t+1 ( I nt+1 I nt ) 2 f ( I nt+1 I nt ) I nt = I t δ(u t ))K t 22

Retail Firms Monopolistically competitive retailers by input from intermediate goods producers and re-package as final output. Set nominal prices on a staggered basis P m,t is marginal cost ((P m,t ) 1 is the markup). 23

Resource and Government Budget Constraints Resource Constraint Y t = C t + I t (1 + f à Int I nt 1! )+G + τψ t Q t K t+1 Government Budget Constraint G + τψ t Q t K t+1 = T t +(R kt R t )B gt 1 24

Central Bank Policy Interest Rate Policy with i t =(1 ρ)[i + ι π π t + ι y (log Y t log Y t )+ρi t 1 + ε t Credit Policy 1+i t = R t+1 P t+1 P t ψ t = ψ + ν[e t (R kt+1 R t+1 ) (R k R)] 25

Table 1: Parameters Households β.99 Discount rate h.79 Habit parameter χ 5.13 Relative utility weight of labor ϕ.279 Inverse Frisch elasticity of labor supply Financial Intermediaries λ.381 Fraction of capital that can be diverted ξ.2 Proportional transfer to the entering bankers θ.972 Survival rate of the bankers Intermediate good firms α.33 Effective capital share u 1. Steady state capital utilization rate δ(u).25 Steady state depreciation rate ζ 5.8 Elasticity of marginal depreciation with respect to utilization rate Capital Producing Firms η i 2.95 Inverse elasticity of net investment to the price of capital Retail firms ε 5. Elasticity of substitution γ.84 Probability of keeping prices fixed γ P.5 Measure of price indexation Government κ π 1.5 Inflation coefficient of the Taylor rule κ X.5 Markup coefficient of the Taylor rule G Y.2 Steady state proportion of government expenditures

Figure 1: Responses to Technology (a), Monetary (m) and Wealth (w) Shocks Y I.2 6 x 1 3 R k R.5 a.1.2.4 4 2.15.6 2 4 2 4 2 2 4 x 1 3 Y.1 I 8 x 1 3 R k R 2 m 4.1.2 6 4 2 6.3 2 4 2 4 2 4 N.5 1 1.5 x 1 3 Y 2 2 4 5 5 x 1 3 I 1 2 4 3 x 1 3 R k R 2 1 2 4 FA SDGE

.5 Figure 2: Responses to a Capital Quality Shock ξ 2 4 Y.5.5 R 2 4.5.2.4.5.6 2.8 4 2 4.1 K.5.2.5 2 4 2 4 C L.5.5.5 R k R 2 4.5 2 4.2.2 2 4 N.4 π.4 i.2.2.5.2.2 1 2.4 4 2.4 4 2 4 I Q FA SDGE

.5.5.5 Figure 3: Responses to a Capital Quality Shock with Credit Policy ξ 2 4 Y 2 4 K.5.5 R 2 4 C.2.4.6.8 2 4 L.5.1.2.5 2 4 2 4 N π.4.2.5.2.4 1 2 4 ψ.2 2 4.5.5 R k R 2 4 I.5.5 2 4 Q.2.2 2 4 i.4.2.2.4 2 4.1 2 4 CP ν=1 CP ν=1 CP ν=

Welfare and Optimal Policy Household Utility Ω t = U(C t,l t )+βe t Ω t+1 Take a quadratic approximation and combine with a quadratic of the model. Solve numerically for the reduced form, given values of the policy-parameters. Find numerically the optimal value of the credit policy parameter υ conditional on a "crisis" shock. Find the consumption adjustment equivalent that the makes the houshehold indifferent between the optimal policy response vs. no response. 26

Figure 4: One year consumption equivalent net welfare gains from optimal credit policy (Ω) and optimal credit policy coefficient (ν) as a function of efficiency costs τ.8.6.4 Ω.2.2.2.4.6.8.1.12 τ 3 25 2 ν 15 1 5.2.4.6.8.1.12 τ 5

Figure 1: Impulse responses to the capital quality shock with premium policy parameter κ Rk R = 1, credible and non-credible (for 2 quarters) policies.2.4 ξ 2 4 Y.5.5 R 2 4.5.2.4.5.6 2.8 4 2 4.1.2.5 2 4 2 4.5 K N.5.4.2.2 1.4 2 4 2 4 C L π.5.5.5 R k R 2 4.5 2 4.2.2 2 4.2.2.4.6.8 I Q i 2 4 Non credible Credible