does monetary policy have an affect on financial stability?

MONETARY POLICY AS FINANCIAL STABILITY REGULATION∗

JEREMY C. STEIN

This article develops a model that speaks to the goals and methods of financial stability policies. There are three main points. First, from a normative perspective, the model defines the fundamental market failure to be addressed, namely, that unregulated private money creation can lead to an externality in which intermediaries issue too much short-term debt and leave the system excessively vulnerable to costly financial crises. Second, it shows how in a simple economy where commercial banks are the only lenders, conventional monetary policy tools such as open-market operations can be used to regulate this externality, whereas in more advanced economies it may be helpful to supplement monetary policy with other measures. Third, from a positive perspective, the model provides an account of how monetary policy can influence bank lending and real activity, even in a world where prices adjust frictionlessly and there are other transactions media besides bank-created money that are outside the control of the central bank. JEL Codes: E58, G01.

I. INTRODUCTION

The modern literature on monetary policy emphasizes the central bank’s role in fostering price stability.1 Historically, however, a dominant concern for central bankers has been not just price stability but also financial stability. Goodhart (1988) argues that the original motivation for creating central banks in many countries was to temper the financial crises associated with unregulated “free banking” regimes:

In the nineteenth century, the advocates of free banking argued that the banking system could be trusted to operate effectively without external con- straints or regulation. . . . [But] experience suggested that competitive pressures in a milieu of limited information (and, thence, contagion risks) would lead to procyclical fluctuations punctuated by banking

∗Eduardo Davila and Fan Zhang provided outstanding research assistance. I am grateful for comments from Robert Barro, Effi Benmelech, Ricardo Caballero, Emmanuel Farhi, Mark Gertler, Marvin Goodfriend, Robin Greenwood, Sam Hanson, Larry Katz, Arvind Krishnamurthy, Jamie McAndrews, David Scharfstein, Andrei Shleifer, Robert Vishny, the referees, and seminar partici- pants at numerous institutions. Thanks also to Mary Goodman, Sam Hanson, Matt Kabaker, Andrew Metrick, Charlie Nathanson, Larry Summers, and Adi Sunderam for a series of early conversations that helped shape the ideas in this article.

1. See, for example, Goodfriend (2007) for a recent articulation of this view.

c© The Author(s) 2012. Published by Oxford University Press, on the behalf of President and Fellows of Harvard College. All rights reserved. For Permissions, please email: journals. [email protected]. The Quarterly Journal of Economics (2012) 127, 57–95. doi:10.1093/qje/qjr054. Advance Access publication on January 6, 2012.

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panics. It was this experience that led to the forma- tion of noncompetitive, non-profit maximizing Central Banks. (p. 77)

A related emphasis on crisis mitigation is evident in Bagehot’s (1873) famous discussion of the lender-of-last-resort function.2 Certainly, recent events have served to underscore the importance of the central bank’s role in preserving financial stability.

In this article, I develop a model that speaks to the goals and methods of central bank financial stability policies. The first step is to define the fundamental market failure that needs to be addressed. I begin with an unregulated banking system in which banks raise financing from households to invest in projects. Banks can raise this financing in the form of either short-term or long-term debt. Households are risk-neutral with respect to fluctuations in their consumption, but derive additional monetary services from holding any claim that is entirely riskless—with the notion being that riskless claims are easy to value and hence facilitate exchange among households. I show that banks can manufacture some amount of riskless private “money” of this sort, thereby lowering their financing costs. Moreover, they can do so in greater quantity by issuing short-term debt, because it is harder for long-term bank debt to be made risk-free.

The role for financial stability policy arises because the pri- vate choices of unregulated banks with respect to money creation are not in general socially optimal. When banks issue cheaper short-term debt, they capture its social benefits, namely, the monetary services it generates for households. However, they do not always fully internalize its costs. In an adverse “financial crisis” state of the world, the only way for banks to honor their short-term debts is by selling assets at fire-sale prices. I show that in equilibrium, the potential for such fire sales may give rise to a negative externality. Thus, left to their own devices, unregulated banks may engage in excessive money creation and may leave the financial system overly vulnerable to costly crises.3

2. Tucker (2009) paraphrases Bagehot’s (1873) dictum as follows: “to avert panic, central banks should lend early and freely (i.e., without limit) to solvent firms, against good collateral, and at ‘high rates.”’

3. Gersbach (1998) and Hart and Zingales (2011) are other papers in which unregulated banks create a socially excessive quantity of private money. However, the externalities in these papers are unrelated to financial stability.

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There are a variety of ways for a regulator to address this externality. One possibility is the use of conventional monetary policy tools, that is, open-market operations. To see how monetary policy might be of value, note that a crude approach to dealing with the externality would be for the regulator to just impose a cap on each bank’s total money creation. However, when the regulator is imperfectly informed about banks’ investment opportunities, he will not know where to set the cap, since it is desirable for banks with stronger investment opportunities to do more money creation. In this setting, the regulator can do better with a flexible “cap-and-trade” system in which banks are granted tradable per- mits, each of which allows them to do some amount of money creation.4 The market price of the permits reveals information about banks’ investment opportunities to the regulator, who can then adjust the cap accordingly—when the price of the permits goes up, this suggests that banks in the aggregate have strong investment opportunities, so the regulator should loosen the cap by putting more permits into the system.

All of this may sound a bit like science fiction; we don’t observe cap-and-trade regulation of banks in the real world. However if banks’ short-term liabilities are subject to reserve requirements, it turns out that monetary policy can be used as a mechanism for implementing the cap-and-trade approach. When the central bank injects reserves into the system, it effectively increases the number of permits for private money creation. The nominal inter- est rate, which captures the cost of holding reserves, functions as the permit price. Thus, open-market operations that adjust aggregate reserves in response to changes in short-term nominal rates can be use to achieve the cap-and-trade solution.

An interesting benchmark case is where reserve require- ments apply to the money-like liabilities of all lenders in the economy. This allows the central bank to precisely control private money creation with monetary policy alone. Although this case may roughly capture the situation facing central banks at an earlier period in history, it is less realistic as a description of modern advanced economies. Nowadays there are a range of short-term financial intermediary liabilities that are not subject to reserve requirements, and yet may both provide monetary services and create fire-sale externalities. For example, Gorton

4. Kashyap and Stein (2004) suggest using an analogous cap-and-trade approach to implement time-varying bank capital requirements.

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and Metrick (2011), and Gorton (2010) argue that an important fraction of private money creation nowtakes place entirely outside of the formal banking sector, via the large volumes of short-term collateralized claims created in the “shadow banking” sector.

In this richer environment, monetary policy as convention- ally practiced is generally not sufficient to rein in excessive money creation. Continuing with the foregoing example, it may additionally be necessary to regulate the volume of activity in the shadow banking sector, either by expanding the reach of reserve requirements or by some other means. Thus the model helps make clear the circumstances under which monetary policy needs to be supplemented with other measures. Moreover, it sug- gests that these other measures lie squarely in the central bank’s traditional domain, to the extent that they are also targeted at the fundamental externality associated with excessive private money creation. This is of interest in light of the ongoing debate over the appropriate mix of central bank tools for achieving financial stability.5

In addition to its normative implications, the model is also relevant from a positive perspective. It provides a coherent account of how monetary policy “works”—that is, of how open market operations lead to changes in bank lending and output— in an environment that is arguably more realistic than in other theories. In contrast to the usual model, prices are fully flexible. Moreover, I do not need to assume that the central bank has monopoly control over all forms of transactions media. The model is unchanged if one introduces a set of nonreservable securities that provide the same monetary services as bank-created money.6

Indeed, I consider the limiting case where the interest rate spread between money and bonds is fixed and unresponsive to their rela- tive supplies. Monetary policy works in this case not by changing real interest rates but through a pure quantity effect: a loosening of policy allows banks to finance themselves with more of the cheaper money, which encourages them to do more lending.

5. See, for example, Adrian and Shin (2008) and Ashcraft, Garleanu, and Pedersen (2010).

6. To be clear on the distinction: my model assumes that the central bank acts as a regulator, controlling those forms of private money creation that lead to negative externalities—in particular, short-term bank debt that finances risky long-term assets. However, it does not require the central bank to control more benign forms of money creation, for example, money market fund accounts backed exclusively by Treasury bills.

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The ideas in this article connect to several strands of pre- vious work. First, the basic model of fire sales that creates the rationale for policy intervention draws on Shleifer and Vishny (1992, 1997).7 Second, the insight that banks create a valuable transactions medium by issuing low-risk claims is formalized in Gorton and Pennacchi (1990). Third, the notion that central bank reserves can be thought of as permits that allow banks to do more of a particular kind of cheap financing appears in Stein’s (1998) elaboration of the bank lending channel of monetary policy transmission.8

Finally, to focus on the financial stability consequences of monetary policy, it helps to set aside its effects on price stability. I do so by appealing to the fiscal theory of the price level, according to which the price level is determined not by the monetary base but by total outstanding nominal government liabilities—that is, by the sum of Treasury securities and the monetary base.9 This enables open market operations that change the mix of Treasuries and bank reserves (while keeping their sum constant) to have real effects on bank investment and financing behavior, even in a world where all prices are perfectly flexible. However, I also discuss how the model’s conclusions carry over to an alternative New Keynesian setting with sticky prices, where price stability is governed by a version of the “Taylor rule” (Taylor 1993, 1999).

The rest of the article is organized as follows. Section II devel- ops the basicmodel of private money creation by banks. Section III compares banks’ financing choices to the social planner’s solution and clarifies the conditions under which banks engage in excessive money creation. It also shows that a cap-and-trade approach to regulation can be useful when the social planner has imper- fect information. Section IV demonstrates how the cap-and-trade approach can be implemented with open market operations. Section V explores a number of other complementary policy tools; these include liquidity regulation, deposit insurance, and a lender-of-last-resort function, as well as regulation of the shadow

7. On fire sales, see also Kiyotaki and Moore (1997), Gromb and Vayanos (2002), Morris and Shin (2004), Allen and Gale (2005), Fostel and Geanakoplos (2008), Brunnermeier and Pedersen (2009), Stein (2009), Caballero and Simsek (2010), and Geanakoplos (2010).

8. For early work on the bank lending channel, see also Bernanke and Blinder (1998, 1992); Kashyap, Stein, and Wilcox (1993); and Kashyap and Stein (2000).

9. The fiscal theory is developed in Leeper (1991), Sims (1994), Woodford (1995), and Cochrane (1998). My own adaptation of the theory is particularly indebted to Cochrane’s exposition.

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banking sector. Section VI discusses how the model differs from other accounts of the monetary transmission mechanism. Conclu- sions are in section VII.

II. A MODEL OF PRIVATE MONEY CREATION

The model features three sets of actors: households, banks, and “patient investors.” I begin by describing each of these groups, and then turn to the optimization problem faced by the banks.

II.A. Households

There are three dates, 0, 1, and 2. At time 0, households have an initial endowment of the one good in the economy. They can either consume this endowment at time 0, or invest some of it in financial assets and consume the proceeds from investment at time 2. They have linear preferences over consumption at these two dates. In addition to consumption, households also derive utility from monetary services. The key assumption is that monetary services can be provided by any privately created claim on time 2 consumption, so long as that claim is completely riskless.10 Thus the utility of a representative household is given by:

(1) U = C0 + βE(C2) + γM,

where M represents the household’s time 0 holdings of privately created “money.”11 To be clear on the notational convention, when a household has M units of money at time 0, this means that it holds claims guaranteed to deliver M units of time 2 consumption.

10. This assumption is meant to capture the spirit of Gorton and Pennacchi (1990) and Dang, Gorton, and Holmstrom (2009). These papers argue that information-insensitive securities are an attractive medium of exchange because they eliminate the potential for adverse selection between transacting parties. My formulation implies that households do not derive monetary services from state- contingent deposits (as in Hellwig 1994). If they did, efficiency might be improved by having banks issue claims that pay a lower return in bad states of the world. However, if some agents have a better ability than others to forecast when the bad state is coming, such state-contingent claims would be subject to adverse selection problems.

11. In a similar formulation, Krishnamurthy and Vissing-Jorgensen (2010) put the stock of Treasury securities directly into the representative agent’s utility function. As one rationale for doing so, they cite the “surety” of Treasuries—that is, the fact that Treasuries are riskless. Like I do, they posit that surety has an extra value above and beyond what is captured in a standard asset pricing model. See also Sidrauski (1967) for an early model with money in the utility function.

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Given their linear form, household preferences pin down two real rates. The first is the (gross) real return on risky “bonds” that pay off at time 2, given by RB = 1

β . The second is the

(gross) real return on riskless “money,” given by RM = 1(β+γ) , where β + γ < 1. The latter follows from the observation that a household is always indifferent between having: (1) β + γ units of time 0 consumption; or (2) a riskless claim that promises one unit of time 2 consumption, since such a claim delivers β of utility from expected future consumption, along with an additional γ of utility in monetary services. The bottom line is that because riskless money offers households a convenience yield that risky bonds do not, in equilibrium it must have a lower rate of return.

The idea that money has a lower return in equilibrium than bonds is standard in textbook models. But here, the return spread is fixed and independent of the quantities of money and bonds, thanks to the linear preferences on the part of households. This feature is not necessary for anything that follows and is easily relaxed. However, it serves to highlight a key novelty of my model: here, changes in central bank policy work not by altering the real rates on either type of claim but by varying the proportions of each that banks use. In other words, looser policy encourages banks to lend more by enabling them to tilt their capital structure toward cheap money financing, thereby lowering their weighted average cost of funds.

II.B. Banks

Households cannot invest their time 0 endowments directly in physical projects, because they do not have the monitoring expertise to do so. This investment must be undertaken by banks, who in turn issue financial claims—in the form of either riskless money or risky bonds—to households. There is a continuum of such banks, with total mass of one. Each bank faces the following investment opportunities. If an amount I is invested at time 0, and the good state prevails, which happens with probability p, total output at time 2 is given by the concave function f (I) > I. If instead the bad state prevails, total expected output at time 2 is λI ≤ I, and there is a positive probability that output collapses all the way to zero. In particular, in the bad state, output is either λIq with probability q, or zero with probability (1 − q).

At time 1, there is a public signal that reveals whether the good or bad state will be realized at time 2. At time 1 it is also

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possible for a bank to sell any fraction of its existing physical assets to a patient investor.12 If a fraction Δ of the assets are sold, total proceeds to the bank are given by Δ kλI, where 0 ≤ k ≤ 1, and the remaining unsold assets yield output at time 2 to the bank of (1−Δ)λI. Thus k is a measure of the discount to expected value associated with a time 1 asset sale. A central feature of the model is that k is endogenous and depends on total asset sales by all banks in the economy. The equilibrium determination of k will be discussed shortly.

Other than their access to investment opportunities, banks have no initial endowments, and hence must raise the entire amount I externally. They can do so by issuing either short-term (maturing at time 1) or long-term (maturing at time 2) debt claims to households. Note that if they finance with long-term debt, no amount of this debt can ever be riskless, because there is a positive probability of the assets yielding zero output at time 2. By contrast, short-term debt can be made riskless, if not too much is issued. This is because by forcing an asset sale on seeing a bad signal at time 1, short-term creditors can escape early with a sure value equal to the proceeds from the sale.

These assumptions are starker than they need to be. In a more general model where the lowest possible value of output at time 2 is greater than zero, banks can issue some riskless long- term debt—so there is no longer a one-to-one mapping between debt maturity and the ability for debt to be made risk-free. Nevertheless, it will always be the case that banks can create a larger quantity of riskless claims by issuing short-maturity debt; the early escape intuition still holds. Because there is a fixed premium on riskless claims, banks will continue to be tempted to issue short-term debt in this more general version of the model, and all the qualitative results that follow will continue to apply.

The model can also be extended so that monetary services are provided not only by entirely riskless assets but by any claims that are sufficiently low risk—that is, by any claims whose worst-case payoff is at least x cents on the dollar. What is critical is that there still be a violation of the Modigliani and Miller (1958) conditions, so that as a bank manufactures more of these low-risk money-like claims, it does not have to pay more for its remaining long-term debt, which becomes riskier. This M-M violation is captured here

12. Because households only consume at time 0 and time 2, they do not consume the proceeds of any time 1 asset sales until time 2. One can think of them as simply sitting on these proceeds in the interim.

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in the assumption that the return on nonmonetary claims, RB, is a constant.

In any of these formulations, the key trade-off is this: on one hand, banks have an incentive to issue some short-term debt, because more of this debt can be made low-risk—and hence by virtue of its money-ness, represents a cheap form of finance.13

On the other hand, what keeps short-term debt safe is the bank’s ability to sell assets in the bad state. As will become clear, these sales of existing assets can lead to social costs that are not always fully internalized by individual banks when they pick their capital structures. As a result, there may be excessive private money creation by banks.

Suppose that a bank raises a fraction m of its total investment of I by issuing short-term debt. If this short-term debt can be made riskless, it will carry a rate of return of RM , and the bank will owe its short-term creditors a repayment of mIRM ≡ M. Can it meet this promise in the bad state by selling assets if necessary? From before, if it sells a fraction Δ of its assets, total proceeds are Δ kλI, so we require that:

(2) Δ kλI = mIRM , orΔ = mRM

kλ .

Since Δ ≤ 1, there is an upper bound on private money creation given by:

(3) mmax = kλ RM

.

Thus, the potential for asset sales makes it possible for a bank to create riskless private money by issuing short-term debt—as long as the amount issued is not too large.

Is it also the case that asset sales are an unavoidable con- sequence of money creation? One might think that since holding on to assets is positive NPV relative to selling them at time 1, it might be possible for a bank to raise new funding at time 1 to pay off the departing short-term creditors, and thereby avoid forced sales. However, if one assumes that any new funding must be subordinated to existing long-term debt, such new funding may be blockaded by a severe debt overhang problem (Myers 1977),

13. Other theories of short-term financing include Flannery (1986), Diamond (1991), and Stein (2005), who stress its signaling properties, and Diamond and Rajan (2001), who argue that short-term debt is a valuable disciplining device, particularly for financial intermediaries.

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given the low value of the assets in the bad state relative to the total face amount of already-issued debt.14 Thus, under plau- sible circumstances, private money creation inevitably leads to some amount of asset sales.15

Note that I assume that banks invest all the resources that they raise at time 0 in real projects and do not hold any back as a buffer against a loss of funding at time 1. However, this is without loss of generality, since a bank always has the option to change the mix of its short-term versus long-term debt, which has a similar buffering benefit and is more cost-effective. In other words, there are two ways to reduce asset sales in the bad state by $1: either borrow an extra dollar of long-term debt at time 0 and park the proceeds in storage, or borrow an extra dollar of long-term debt at time 0 so as to reduce the amount of short-term borrowing by $1. The net cost of the former transaction is (RB − 1), and the net cost of the latter is (RB − RM ). Hence, the latter approach is strictly preferred, and banks endogenously choose not to engage in storage.

Before moving on, it is worth fleshing out an issue of inter- pretation about the banks in the model. In the real world, banks do not invest in physical projects directly, but lend to firms who in turn do the project selection. Abstracting away from this extra layer of activity, as I do here, is tantamount to assuming that there are no contracting frictions between operating firms and banks, that is, that firms can costlessly pledge all of their output to the banks. This raises the question of whether it is appropri- ate to interpret what I label “banks” as really being financial

14. In particular, denoting the face value of the existing long-term debt by B, it must be that M + B > I, for the bank to have raised I at time 0 by issuing money and bonds. If the bank now wants to raise an amount M to pay off the short-term creditors in the bad state at time 1, it must do so by issuing new claims that are junior to the existing long-term debt. But given that they are junior, the value of these claims in the bad state is only q(λI/q − B). For q large enough (certainly for q > λ) the value of the new claims is necessarily less than M, so refinancing the short-term debt is impossible.

15. This line of argument leaves open the question of why the original long- term financing for the bank is in the form of senior debt, as opposed to, say, equity, or some other junior security that allows for new financing to come in on top of it. Following Hart and Moore (1995), it may be that this seniority of the long- term debt represents a valuable precommitment in the more likely good state of the world. For example, it may prevent managers from using assets in place as collateral for empire-building investments. Thus, as in Hart and Moore, senior long-term debt is a double-edged sword: it serves to discipline wayward managers in the good state, but forces underinvestment (here, in the form of asset sales) in the bad state.

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intermediaries, as opposed to operating firms that borrow directly from households in the securities market.

To create a meaningful distinction, suppose that any individ- ual operating firm, once funded, always has some probability of immediate (i.e., before time 1) idiosyncratic failure, in which case it becomes publicknowledge that its output will be zeroin both the good and bad states. This risk of failure makes it impossible for an operating firm to ever issue riskless claims in any amount. Banks, on the other hand, represent highly diversified portfolios of such firm-level projects, and therefore their assets always have positive expected value as of time 1, as assumed. The diversification associated with banks is thus a necessary condition for them to create riskless claims.16

II.C. Patient Investors

Patient investors (PIs) are another type of intermediary, and as such, any output that they produce reverts to the household sector at time 2. As a group, PIs are endowed with resources of W at time 1. For simplicity, I treat this endowment as exogenous for now, but it can be endogenized by allowing the PIs to raise the W from the household sector at time 0 by issuing risky long-term claims. In this case, the PIs choose an optimal level of W at time 0 that equates the expected return on their time 1 investments to the cost of capital RB. Imposing this ex ante breakeven condition does not affect the qualitative results of the model, so I set it aside for the time being.

What is crucial is that when time 1 rolls around and the state of the world is realized, W is fixed. Thus, although it is fine to think of PIs as having full access to financial markets at time 0, they cannot go back and raise more at time 1 once they know the state. In other words, W is an unconditional war chest, with the same amount available to PIs in the good and bad states. This assumption can be thought of as a crude stand- in for the phenomenon of “slow-moving capital” (Duffie 2010). A more explicit micro-foundation might involve an information asymmetry between PIs and households at time 1—for example, the PIs get a private signal about the quality of their investment

16. Thus, as in other models of intermediation, both pooling (i.e., diversifica- tion) and tranching (i.e., the issuance of properly structured senior securities) have roles to play in creating low-risk claims. See, for example, Gorton and Pennacchi (1990), DeMarzo and Duffie (1999), and DeMarzo (2005). Diamond (1984) also emphasizes the importance of diversification to the process of intermediation.

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opportunities at this time, which creates an adverse selection problem for any further attempts to raise financing.

PIs can do one of two things with their resources at time 1. First, they can invest in new, late-arriving real investment projects. Irrespective of the state of the world, an investment of K in such new projects at time 1 yields expected gross output of g(K) at time 2, where g( ) is a concave function. Alternatively, PIs can absorb assets being sold by banks at time 1. In the good state, there are no asset sales, so the PIs invest all of W in new projects, yielding g(W). In the bad state, banks have to sell enough assets to repay short-term creditors the M they have promised them. Thus in equilibrium, PIs spend M on asset purchases, and invest only (W − M) in new projects, yielding g(W − M). For the PIs to be willing to allocate their endowment in this way, it must be that the marginal return on new projects is the same as the marginal return from buying existing assets from banks. This is what pins down the fire-sale discount k. In particular, we have that:

(4) 1 k

= g′(W − M).

Equation (4) makes clear the real costs of fire sales, and hence of short-term debt financing by banks. The greater is M, and hence the more bank assets that the PIs have to absorb in the bad state at time 1, the less they have left over for investment in new projects. With scarce PI capital, the return on secondary market arbitrage opportunities (buying up fire-sold assets) also becomes the hurdle rate for new investment, a point emphasized by Diamond and Rajan (2009) and Shleifer and Vishny (2010).

For expositional purposes, I treat the PIs and the banks as two distinct categories of intermediaries. This is not necessary; one could alternatively merge them into a single entity that has investment opportunities at both time 0 and time 1, issues some short-term debt at time 0, and also holds liquidity W in reserve at time 0. This reinterpretation of the model is innocuous, subject to one caveat: it is crucial that the merged entities behave not as autarkic islands but as price-takers who can transact in the asset market at time 1. Thus, even if a bank satisfies most of its departing creditors by drawing down on its own stock of liquidity at time 1, it must continue to consider the possibility of asset sales to another bank. This feature emerges naturally if we move away from the knife-edge case where the scales of time 0 and time 1 investment are in identical proportions across all banks.

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If so, those that have relatively bigger time 1 scale will tend to stockpile more W relative to their short-term debts, and hence will be buyers of assets from those who have bigger time 0 scale. My two-categories formulation can be thought of as capturing an extreme case of this heterogeneity.

II.D. The Bank’s Optimization Problem

I formulate the optimization problem for a bank that invests an amount I and finances it with some fraction m ≤ mmax of money. The bank’s expected net profits at time 2 are given by:

(5) Π = {pf (I) + (1 − p)λI − IRB} + mI(RB − RM )− (1 − p)zmIRM ,

where I have defined z = (1−k)k as the net rate of return on fire-sold assets. (Note that higher values of z correspond to larger fire-sale discounts, and z = 0 is the case where there is no discount.) The three terms in equation (5) are easily interpreted. The first, {pf (I) + (1 − p)λI − IRB}, is the NPV of investment assuming that it is entirely financed at the higher bond market rate—and hence that there is no need to ever sell assets. The second term, mI(RB−RM ), is the financing cost savings associated with using a fraction m of money in the capital structure. The last term, (1 − p)zmIRM , captures the expected fire-sale losses associated with this riskier short-term capital structure.

Each bank picks m and I to maximize equation (5), subject to the collateral constraint that m ≤ mmax = kλ

RM . I assume that each

bank treats the fire-sale discount k as a fixed constant—that is, they do not internalizxe the incremental impact of their choices on the fire-sale outcome. By contrast, when I examine the social planner’s problem, the key difference will be that the planner takes into account the dependence of k on the capital structure of the banks. The Lagrangian for the bank’s problem is thus: (6)

LB ={pf (I) + (1−p)λI−IRB} + mI(RB−RM )−(1−p)zmIRM−η(m− kλ RM

),

where η is the shadow value of the collateral constraint. Taking the first-order condition with respect to m, we have:

(7) I{(RB − RM )− (1 − p)zRM} = η.

It follows that the collateral constraint binds, and the bank is at a corner, setting m = mmax, if (RB −RM ) > (1−p)zRM , that is, if the equilibrium spread between bonds and money is sufficiently

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large. Alternatively, if the spread is smaller in equilibrium (that is, if (RB − RM ) = (1 − p)zRM ), then the bank chooses an interior value of m, and η = 0.

The first-order condition with respect to I yields:

(8) pf ′(I) + (1 − p)λ− RB + m(RB − RM )− (1 − p)zmRM = 0.

Using equation (7), we can rewrite equation (8) as follows:

(9) pf ′(I) + (1 − p)λ− RB = −ηm

I .

There are two ways that equation (9) can be satisfied. First, the bank can be at an interior solution with respect to m, in which case η = 0, and therefore pf ′(I) + (1 − p)λ = RB. Alternatively, the bank can be at a corner with m = mmax, and η > 0, in which case it follows that pf ′(I) + (1 − p)λ < RB. This reasoning leads to the following proposition.

PROPOSITION 1. Define IB as the optimal level of investment for a bank that finances itself exclusively in the long-term bond market: pf ′(IB) + (1 − p)λ− RB = 0. The solution to the bank’s problem involves two regions. In the low-spread region (for (RB − RM ) relatively small) the bank chooses m < mmax and I∗ = IB. In the high-spread region (for (RB − RM ) relatively large) the bank chooses m = mmax and I∗ > IB.

The point to take away from the proposition is that in the low-spread region, a bank’s investment and financing choices are decoupled, whereas in the high-spread region they are interde- pendent. This is because when m < mmax, a bank’s ability to tap low-cost money financing is not constrained by the amount of investment it does. By contrast, in the high-spread region in which m = mmax, a bank faces a binding collateral constraint—it can only issue more money if it increases the quantity of physical assets backing its debts. This is what ties investment and financing decisions together. If money financing is cheap enough that banks want to do a lot of it, and they begin to bump up against the collateral constraint, they will be induced to invest more so as to loosen the constraint.

III. SOCIALLY EXCESSIVE MONEY CREATION: A ROLE FOR REGULATION

The next step in the analysis is to identify the circumstances in which the process of private money creation already described

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MONETARY POLICY AS FINANCIAL STABILITY 71

involves an externality—that is, when the level of money creation chosen by banks exceeds that preferred by a benevolent social planner.

III.A. The Social Planner’s Problem

Given that all output of the banks and the PIs ultimately accrues to the household sector, the social planner seeks to maximize the utility of a representative household, as given by equation (1). It is easily shown that, disregarding constants, this utility, expressed in units of time 2 consumption, is equivalent to:17

U = {pf (I) + (1 − p)λI − IRB} + M (RB − RM)

RM + pg(W)(10)

+(1 − p){g(W − M) + M}− WRB.

Comparing this to the bank’s expected profits in equation (5), we can see that the first two terms coincide. The difference is in the latter three terms: the planner does not care about expected fire-sale losses per se, because these only represent a transfer from the banks to the PIs. However, the planner does care about the net expected returns to investment by the PIs, as captured by pg(W)+ (1 − p){g(W − M) + M}− WRB.

The planner faces the same collateral constraint as the banks, namely, that m ≤ mmax = kλ

RM . Denoting the shadow value of the

constraint in this case by ηP, and recalling that M = mIRM , the Lagrangian for the planner’s problem is given by:

LP = {pf (I) + (1 − p)λI − IRB} + mI (

RB − RM )

+ pg(W)(11)

+ (1 − p){g(W − mIRM ) + mIRM}− WRB −ηP (

m − kλ RM

) .

In taking the first-order conditions for this problem, it is important to note that unlike an individual bank, the planner recognizes the dependence of k on the average behavior of all banks—he understands that, as per equation (4), k = 1

g′(W−mIRM ) .

17. In particular, suppose households have a fixed time 0 endowment of Y, and that they invest I of this endowment with the banks and W with the PIs at time 0. It follows that C0 = Y − I − W, and that C2 = f (I) + g(W) with probability p, and C2 = λ I + g(W − M) + M with probability (1 − p). The expression in equation (10) then follows from also including the monetary services γM in the utility function, and multiplying time 0 values by RB to put everything in common units of time 2 consumption.

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Using this fact, the first-order condition with respect to m can be written as:

(12) I{(RB − RM)− (1 − p)zRM} = ηP (

1 − g′′( ∙ )

(g′( ∙ ))2 λI

)

.

Similarly, the first-order condition with respect to I can be expressed as: (13)

pf ′(I)+ (1−p)λ−RB + m(RB−RM )−(1−p)zmRM =−ηP g′′( ∙ )

(g′( ∙ ))2 λm.

Comparing equations (7) and (12), and equations (8) and (13), we can see that the bank’s private solution coincides exactly with the social planner’s solution in the low-spread region where (RB − RM ) = (1 − p)zRM , and where the collateral constraint is nonbinding, that is, where η = ηP = 0. In this case, equation (13) reduces to equation (8), meaning that the planner chooses the same level of I as the bank.

By contrast, in the high-spread region where the constraint binds, so that ηP > 0, the term on the right-hand side of equation (13), −ηP g

′′(∙) (g′(∙))2 λm, describes the wedge between the bank’s solu-

tion and the planner’s solution. Since g′′( ∙ ) < 0, this term is positive, which implies that the marginal product of investment is higher in the social planner’s solution, or alternatively that I is lower. In other words, in this region, the social planner would like to restrain investment, and hence money creation, relative to the private outcome.

The following proposition summarizes the analysis.

PROPOSITION 2. Denote the private and socially optimal values of investment I by I∗ and I∗∗, respectively, and similarly for the private and socially optimal values of money creation M. In the low-spread region, I∗ = I∗∗, and M∗ = M∗∗. In the high- spread region, I∗ > I∗∗, and M∗ > M∗∗.

Thus banks may create a socially excessive amount of money, but this happens only if the spread between money and bonds (RB−RM ) is high enough. If the spread is solowthat any individual bank choose an interior value of money creation m < mmax, there is no divergence between private and social incentives.

EXAMPLE 1. Pick these functional forms and parameter values: f (I) = ψlog(I) + I, g(K) = θlog(K), RB = 1.04; RM = 1.01; ψ = 3.5; θ=150; λ=1; W =140; and p=0.98. For these values, the private

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FIGURE I

Private and Socially Optimal Outcomes versus the Money-Bond Spread

The figure plots private and socially optimal values of money creation M and investment I as a function of RM . Functional forms and parameter values are as follows: f (I) = ψlog(I) + I; g(K) = θlog(K); RB = 1.04; ψ = 3.5; θ = 150; λ = 1; W = 140; and p = 0.98. RM varies between 1.0 and 1.035.

optimum is in the high-spread region and involves banks choosing M∗ = 57.6 and I∗ = 104.9, with an associated rate of return on fire-sale assets of z = 82.1% (k = 0.549). By contrast, in the social optimum, the planner chooses M∗∗ = 55.2 and I∗∗ = 97.7, leading to a rate of return on fire-sale assets of z = 77.0% (k = 0.565).

Figure I expands on Example 1, keeping all of the other parameter values the same as before, but allowing RM to vary between 1.00 and 1.035, thereby causing the bond money spread (RB − RM ) to vary between 50 and 400 basis points. As can be seen, for low values of the spread, the private and socially optimal values of M and I coincide. But as the spread widens, these values diverge further and further from one another.

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III.B. Understanding the Nature of the Externality

At first glance, it may not be clear why fire sales create a divergence between private and socially optimal outcomes. After all, the price impact of liquidations is a pecuniary externality, and pecuniary externalities by themselves need not lead to violations of the standard welfare theorems. The result in Proposition 2 is a specific case of the generic inefficiency result in economies with incomplete markets (Geanakoplos and Polemarchakis 1986; Greenwald and Stiglitz 1986). Perhaps the closest analogs are Caballero and Krishnamurthy (2003) and Lorenzoni (2008), who also show how there can be socially excessive borrowing in economies with various financial frictions. In the current setting, the key friction is the presence of a binding collateral constraint. When this constraint is operative, any one agent’s impact on mar- ket prices affects other agents not only by altering their budget constraints but also by loosening or tightening their collateral constraints. The first welfare theorem effectively says that pecu- niary externalities that operate solely through prices in budget constraints do not lead to inefficiencies, but when prices show up elsewhere, this conclusion no longer holds.

The importance of the collateral constraint can be seen in the expression for the wedge between the bank’s first-order con- dition and that of the planner; as noted, this wedge is given by: −ηP g

′′(∙) (g′(∙))2 λm. Thus when the collateral constraint does not bind,

that is,when ηP = 0, there is no wedge, and the private and social solutions coincide. By contrast, when the collateral constraint binds, there is a wedge to the extent that g

′′(∙) (g′(∙))2 < 0, that is, to

the extent that an increase in liquidations widens the fire-sale discount, or equivalently, raises the marginal product of time 1 investment by the PIs.

The intuition behind this result can be understood as follows. When the constraint does not bind, equation (7) tells us that in deciding howmuch money tocreate, each bank trades offthe lower financing cost (RB−RM ) associated with money against the poten- tial for greater fire-sales discounts (1 − p)zRM . But according to equation (12), this is exactly the same trade-off the planner faces in attempting to balance the marginal value of monetary services to households against the marginal cost of underinvestment by the PIs. Hence in this case, everything is well internalized.

By contrast, when the constraint binds, and each bank is setting m = mmax, an incremental increase in money creation by

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MONETARY POLICY AS FINANCIAL STABILITY 75

any one bank has an added effect: by reducing the equilibrium value of k, it effectively lowers the collateral value of all other banks’ assets, thereby tightening their collateral constraints and impinging on their ability to create money. Thus, when any one bank creates an additional unit of money and captures the private benefit for doing so, the social benefit is less than that one unit of money, because other banks can no longer produce as much M for a given level of I.18

The result that there is no externality in the low-spread region when m < mmax is dependent on the strong assumption that when the PIs invest in real projects, they capture all the social surplus associated with these projects. If one adds another finan- cial friction to the model, and makes this surplus only partially pledgeable, private money creation is always socially excessive, irrespective of parameter values. In particular, suppose that the social return toan investment project financed by a PI is still given by g(K), but onlyϕg(K) can be pledged tothe PI, with ϕ < 1. In this case, the equilibrium determination of k in (4) is altered so that 1 k =ϕg

′(W−M). That is, a given amount of underinvestment by the PIs is now associated with a smaller fire-sale discount. Hence, a bank’s aversion to fire sales no longer leads it to fully internalize the social costs of underinvestment.

This imperfect pledgeability variant of the model is briefly explored in the Appendix. Because it is possible to make many of the key normative points that follow without introducing imperfect pledgeability, there is a certain minimalist appeal to focusing on the perfect pledgeability limit of ϕ = 1, as I do in the remainder of the text. However, if one is interested in generating more realistic comparative statics along some dimensions, the augmented version of the model that allows for ϕ < 1 may be better suited to doing so. For example, I show in the Appendix that the perfect pledgeability version of the model yields the some- what counterintuitive implication that the central bank should lower nominal interest rates when the risk of a financial crisis is greater. If instead we posit that ϕ < 1, this result can easily be reversed.

18. Think of two banks, A and B, as factories that each have a technology for producing money out of physical assets. When the collateral constraint binds, an incremental increase in money production by A is equivalent to a form of pollution that gums up B’s production technology, since it reduces the amount of money that B can manufacture out of a given stock of physical assets.

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III.C. A “Cap-and-Trade” Approach to Bank Liquidity Regulation

The analysis thus far makes clear that in some cases banks will choose to create more money than is socially optimal, thereby inflicting inefficiently high levels of fire sales on the economy. This suggests a role for regulation. In the full information case, in which the regulator observes all the relevant parameters of the model, the social optimum can be easily implemented with a cap on money creation: each bank can simply be prohibited from issu- ing more short-term claims than the desired level of M∗∗, which the regulator can directly compute from equations (12) and (13).

However, if the regulator is imperfectly informed, it becomes more challenging to set the cap appropriately.19 Consider a situ- ation in which banks know the productivity of their investment opportunities—that is, they know what the function f (I) looks like—but the regulator does not. As can be seen from equation (13), the value of I∗∗, and hence the value of M∗∗, depends on the marginal product of investment f ′(I). Intuitively, it makes sense to allow banks to create more cheap money financing when they have better investment opportunities. Thus without knowledge of the value of f ′(I), it is impossible for the regulator to target the socially optimal level of money creation with a simple cap.

One way for the regulator to generate the required informa- tion is through a system of cap and trade. In particular, each bank can be granted permits that allow it to issue some amount of money; by picking the aggregate quantity of permits, the regulator can, as before, effectively target the total amount of money M in the economy. Moreover, if the permits can be traded among banks, their market-clearing price P(M) (per unit of money creation allowed) will equal the shadow value of the M-constraint to the banks:

P(M) = dΠdM = 1

mRM dΠ dI .

20 Conditional on the regulator knowing the other parameters of the model, observing dΠdI allows him to infer the value of f ′(I).

It follows from this reasoning that the regulator can imple- ment the M∗∗ solution by making the permits tradable, and then

19. Weitzman (1974) is the seminal paper on regulation in the face of param- eter uncertainty.

20. Note that because the banks in the model are all identical, the volume of trade in the permits is zero. Nevertheless, there is a unique equilibrium price, given by the common shadow value of the M-constraint.

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MONETARY POLICY AS FINANCIAL STABILITY 77

targeting the appropriate price for these permits by varying the available quantity. That is, the regulator adjusts the quantity of permits, looking for a fixed point where the market-clearing price P(M) equals a target value PT (M) that itself depends on the quantity of permits. To calculate this target value, recall that in the high-spread region when m = mmax, the social optimum involves dΠdI = −η

P g ′′(∙)

(g′(∙))2 λm, which would imply setting P T (M) =

1 mRM

dΠ dI =

−ηPλ RM

. g ′′(∙)

(g′(∙))2 . Using equation (12), we can substitute for

ηP to obtain the following result.

PROPOSITION 3. A regulator who is imperfectly informed about the nature of bank lending opportunities can implement the desired level of money M∗∗ with a system of tradable permits for money creation. This involves adjusting the number of permits such that their observed market-clearing price P(M) equals the following target price PT (M):

(14) PT (M) =

{ (RB − RM )

RM − (1 − p)z

}  



−λI g ′′(∙)

(g′(∙))2( 1 −λI g

′′(∙) (g′(∙))2

)

 

 .

To be clear on the implementation, suppose the regulator picks an initial trial value of M. At this value, the regulator can calculate the target price of permits PT (M) from equation (14), based on his knowledge of M and the other observable parameters of the model—as can be seen from equation (14), he does not need to know anything about the value of f ′(I) to evaluate PT (M). If the market price of permits P(M) turns out to be higher than PT (M), the regulator increases M, and vice versa. The optimum M∗∗ is that value of M where the target price in equation (14) coincides with the market price.

EXAMPLE 2. Keep everything the same as in Example 1: f (I) = ψlog(I) + I, g(K) = θlog(K), RB = 1.04; RM = 1.01; ψ = 3.5; θ = 150; λ = 1; W = 140; and p = 0.98. At the social optimum of M∗∗ = 55.2, the price of permits is P = 0.0056. Now suppose there is a positive productivity shock, and ψ rises to 4.0. If the cap is not adjusted, the price of permits spikes to P = 0.0146. However, this price increase reveals the new value of ψ to the regulator, who can increase the number of permits in the system, raising the quantity of money in the system to its new optimal value of M∗∗ = 58.9. At this new optimum, the price of permits is given by P = 0.0054.

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The example suggests that in the face of productivity shocks, it is optimal for the regulator to actively lean against incipient changes in the price of permits. When a positive shock pushes the price of permits up, the regulator should increase the supply of permits, thereby driving their price back down. In fact, optimality in this setting requires the supply response to be sufficiently strong that the equilibrium price of permits actually falls slightly as productivity rises.

III.D. Relationship to Pigouvian Taxation

A handful of recent papers have suggested that a system of Pigouvian taxes might be used to force banks to properly internalize any systemic externalities they create (e.g., Jeanne and Korinek 2010; Kocherlakota 2010; Perotti and Suarez 2010). In the current context, this would amount to imposing a tax τ on each unit of money created by banks. A couple of points about such taxes are worth noting.

First, in the full information case where the planner observes everything needed to compute the socially optimal level of money creation M∗∗, this outcome can be achieved equally well either with a regulatory cap on money creation, or by picking the correct value of the taxτ. Indeed, given full information, the regulator can implement M∗∗ simply by setting τ = PT (M∗∗), that is, the target price of permits given by equation (14), calculated at the desired value of M∗∗. So Pigouvian taxes can be used, but in this setting they do not add any value relative to more conventional quantity- based regulation.

Second, in the incomplete information case where the planner does not knowenough topick the right level of the cap, he alsodoes not know enough to set the correct value of the tax τ, because the optimal tax depends on M∗∗. Thus, an optimal system of Pigouvian taxation still requires a mechanism to elicit the private information. So the cap-and-trade design remains useful, for the same reasons as before. Indeed, one can interpret the cap-and- trade approach as a “smart” system of Pigouvian taxation, since for any individual bank the permit price is identical to the optimal tax on money creation.21

21. This is not to say that cap-and-trade is the unique way of implementing the optimal scheme. An alternative would be an iterative form of taxation: the regulator announces a trial value of the tax rate. He then observes the quantity of M chosen by banks and uses this to infer the productivity of their investment opportunities. With these data, he can then set the optimal tax rate. Thus rather

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IV. IMPLEMENTING THE CAP-AND-TRADE APPROACH WITH MONETARY POLICY

The cap-and-trade approach to bank regulation may seem alien—it does not have any direct counterpart in the real world. However, I argue that the cap-and-trade approach can be imple- mented with something that looks very much like conventional monetary policy—with open market operations in which the cen- tral bank adjusts the quantity of nominal reserves in the banking system. In this setting, reserves play the role of permits for money creation, given the existence of a binding reserve requirement. And the nominal interest rate corresponds to the price of the permits.

In drawing this analogy, one wrinkle is that I have so far been working in an entirely real economy. To introduce a central bank and a role for monetary policy, I need to bring in a set of nominally denominated government liabilities, and then pin down the price level. To do so, I rely on the fiscal theory of the price level (Leeper 1991; Sims 1994; Woodford 1995; Cochrane 1998). In particular, the government is assumed to issue two types of nominal liabilities: Treasury bills and bank reserves. According to the fiscal theory, the sum of these two nominal liabilities is what is relevant for determining the price level. Given the sum, the composition of these liabilities is a real variable, since only reserves can be used tosatisfy reserve requirements. Thus holding fixed total government liabilities, when there are more reserves, banks are able to create more money, that is, to finance a greater fraction of their operations with short-term debt. Hence, reserves correspond exactly to the concept of regulatory permits in the real model.22 By contrast, if Treasury bills could also be used to satisfy reserve requirements, there would be nothing special about reserves, and open market operations would have no effect.

To operationalize the fiscal theory, I assume that the govern- ment anticipates real tax revenues of T at time 2, and the value of T is exogenously fixed. At time 0, the government has total nominal liabilities outstanding of l0, composed of Treasury bills b0, and bank reserves r0. Thus l0 = b0 + r0. The time 0 price level Λ0, is then determined by the requirement that the real value of

than setting quantities and learning from market prices, the regulator sets prices (taxes) and learns from market-determined quantities.

22. Since the price level is pinned down by fiscal considerations, the goal of achieving price stability cannot be the central bank’s job. Rather, the central bank is left with just the role of financial stability regulator.

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the government’s obligations must equal the present value of its future tax revenues:

(15) l0 Λ0

= T

RM .

Two points are worth noting here. First, the relevant real discount rate for the government is RM , given that its obligations are riskless: when households own Treasury bills, they derive the same monetary services from these bills that they do from privately created bank money, so the return on Treasury bills is equal to RM . Second, to keep real tax revenues fixed at T as the composition of government liabilities varies, I assume that the government rebates any seignorage revenues derived from the issuance of non–interest-bearing reserves in a lump-sum fashion to the household sector.23

Again, the key distinction between Treasury bills and bank reserves is that only the latter can be used to satisfy reserve requirements. In particular, any bank wishing to issue a dollar of short-term debt must hold ρ dollars of reserves, where ρ is the fractional reserve requirement. Hence the net amount of short- term debt financing made possible by $1 of reserves is (1−ρ)

ρ

dollars.24 It follows that in real terms, the total amount of M that can be created by the banking sector is now given by:

(16) M = (1 −ρ)r0 ρΛ0

= (1 −ρ)T ρRM

r0 l0

.

This expression makes it clear that the ratio of r0 to l0— namely, the composition of the government’s nominal liabilities— is a real variable, and is the means by which the government can target total real money creation by banks. An open market operation that increases the supply of reserves relative to T-bills is isomorphic to an increase in the regulatory limit on M in the all-real cap-and-trade version of the model.

23. Without this assumption, the composition of government liabilities would influence real tax revenues. In particular, as the government issued more non– interest-bearing reserves and fewer interest-bearing bills, its effective tax rev- enues would go up through a seignorage mechanism. The assumption can be loosely motivated by the idea that the government has some kind of social compact with its citizens that prevent it from letting total tax revenues—no matter how they are raised—go above T.

24. As an example, suppose ρ = 0.10. In this case, with $1 of reserves, a bank is allowed to raise $10 of short-term debt. But given that it must hold the reserves as an asset, only $9 represent net financing that is available to fund new loans.

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MONETARY POLICY AS FINANCIAL STABILITY 81

Moreover, as noted, the analog to the price of permits is the current setting is the nominal interest rate. This is because when banks want to create money, they are forced to hold non–interest- bearing reserves, and the nominal interest rate represents the opportunity cost of doing so.

Denoting the nominal interest rate by i, one can express the time 2 price level as:

(17) Λ2 = Λ0(1 + i)

RM .

Now suppose a bank wishes to increase its net issuance of real M by one unit at time 0, thereby increasing its real time 2 profits by dΠdM . To do so, it must increase net nominal M by Λ0 units, which requires it to hold ρΛ0/(1−ρ) of nominal reserves. To finance these reserve holdings, it must pay ρiΛ0/(1−ρ) of nominal financing costs at time 2. The real time 2 value of these financing costs is therefore ρiΛ0(1−ρ)Λ2 or, using equation (17),

ρiRM

(1−ρ)(1+i) . For a bank to be indifferent, it must be that these real costs are equal to dΠdM . Thus it follows that the nominal interest rate is given by:

(18) i

(1 + i) =

(1 −ρ) ρRM

dΠ dM

.

EXAMPLE 3. Keep everything the same as in Example 1: f (I) = ψlog(I) + I, g(K) = θlog(K), RB = 1.04; RM = 1.01; ψ = 3.5; θ = 150; λ=1; W =140; and p=0.98. At the social optimum of M∗∗=55.2, we had that dΠdM = 0.0056. With a reserve requirement of ρ = 0.10, if this optimum is implemented with monetary policy, the nominal interest rate is given by i = 5.25%. (Since the nominal rate exceeds the riskless real rate of 1.0%, the implied rate of inflation between time 0 and time 2 is 4.25%.) If we keep all else the same but set RM =1.02, the newoptimum involves M∗∗ = 52.5, which is implemented with a nominal rate of i=1.81%. Intuitively, as the spread between money and bonds shrinks, banks have a weaker desire to create private money. So the nominal interest rate, which is equivalent to the value of a permit for money creation, falls as well.

V. OTHER POLICY TOOLS

V.A. Liquidity Regulation

I have thus far taken the time 0 liquidity stockpile W of the PIs to be exogenous. This does not affect any of the conclusions

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in the foregoing analysis regarding the socially optimal quantity of money, because these conclusions hold for any value of W such that there is a scarcity of PI resources in the bad state at time 1. However, I now pose two related questions about W. First, if the PIs are allowed to choose W optimally, what value will they pick? Second, if the social planner is allowed to choose W, will his choice differ from that of the PIs? In other words, is there a case for regulation of liquidity holdings, in addition to regulation of money creation?

The privately optimal choice of W, denoted by W∗, is deter- mined by the following first-order condition:

(19) pg′(W) + (1 − p)g′(W − M) = RB.

The logic is straightforward. PIs raise W at time 0, paying a gross interest rate of RB.25 With probability p, the good state ensues, and the marginal return on their investment is g′(W). With probability (1 − p), the bad state ensues, and the marginal return on investment is g′(W − M). One interesting feature of this solution is that the more unlikely the bad state, the lower the equilibrium value of W∗, and the deeper the fire-sale discount when the bad state does in fact occur.

To solve for the socially optimal value of W, denoted by W∗∗, we can return to the planner’s Lagrangian from equation (11) and take the first-order condition with respect to W, which yields:

(20) pg′(W) + (1 − p)g′(W − M) = RB + ηP λg′′( ∙ )

RM (g′( ∙ ))2 .

Comparing equations (19) and (20), we can see that the pri- vate and social solutions once again diverge only when ηP > 0, that is, when the collateral constraint binds. Moreover, when this does happen, the additional term in equation (20), ηP λg

′′(∙) RM (g′(∙))2

, is nega- tive, meaning that the planner prefers a lower marginal product of W, or alternatively, a higher level of W. Thus optimal regulation takes the form of a floor on liquidity holdings by the PIs.26

25. The assumption that the PIs’ cost of capital is RB, rather than RM , is tantamount to saying that they are unable to issue any riskless debt. This would be the case if their production technology g(K) were risky, and had some probability of delivering zero output at time 2. However, even if the PIs could issue riskless claims, the rest of the analysis would be little changed, since the return on these claims is already pinned down independent of their quantity. Thus the marginal appeal to the banks of issuing short-term debt against their long-term assets is unaffected if the PIs do some additional riskless financing on the side.

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This result connects to Farhi, Golosov, and Tsyvinski (2009), who also develop a rationale for liquidity regulation. However, the mechanism in FGT is quite different. Following Diamond and Dybvig (1983), Jacklin (1987), Bhattacharya and Gale (1987), and Allen and Gale (2004), they model banks as providers of insurance to consumers with unpredictable liquidity needs. As this litera- ture has shown, incentive-compatible insurance can be frustrated by the existence of securities markets, since “late” consumers may be tempted to mimic “early” consumers by withdrawing their money from the bank prematurely and reinvesting it at the market rate of interest. The insight of FGT is that liquidity requirements can be used to depress the security market rate, thereby reducing the temptation for late consumers to withdraw early. By contrast, in my model, real rates are pinned down by the linear preferences of households and thus unaffected by liquidity requirements. Instead, the rationale for a liquidity requirement reflects a desire to reduce the equilibrium fire-sale discount.27

Although liquidity requirements arise naturally in my frame- work, there are a couple of caveats. First, the liquidity require- ments envisioned by the theory may be difficult to enforce. To implement them efficiently, they have to be imposed on PIs at time 0, in proportion to the scale of each PI’s time 1 investment opportunities. But a regulator may not know at time 0 what the distribution of time 1 projects across PIs looks like. By contrast, the monetary regulation does not face this enforcement problem, since short-term debt issuance is contemporaneously observable at time 0.

Second, in the limited set of numerical experiments that I have tried, the planner’s utility gain from imposing liquidity regulation turns out to be much smaller than that from regulating the creation of private money. Combined with the enforcement problem, this helps explain why the primary focus of the analysis

26. As emphasized, liquidity requirements can never obviate the need for regulation of money creation. One way to show this formally is to note that according to equations (19) and (20), liquidity regulation is only ever worth using when the collateral constraint binds in equilibrium. However, as we have seen, when the collateral constraint binds, it is always desirable to regulate money creation.

27. At a more abstract level, the two models are similar in the following sense. In both models there is an additional constraint beyond the budget constraint: an incentive compatibility constraint in FGT, and a collateral constraint in my model. Moreover, in both models, a market price (the interest rate, or the fire-sale price) enters into the constraint; this is what motivates the planner to intervene, in an effort to change the market price and thereby relax the constraint.

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in this article has been on the latter. The following example is illustrative of the magnitudes that arise.

EXAMPLE 4. Keep everything the same as in Example 1, except allow W to be chosen endogenously: f (I) = ψlog(I) + I, g(K) = θlog(K), RB = 1.04; RM = 1.01; ψ = 3.5; θ= 150; λ= 1; and p = 0.98. The PIs’ optimal choice of W is given by W∗ = 146.31, whereas the social optimum is given by W∗∗ = 147.04. Compared to a benchmark case with no regulation at all, the following regulatory configurations produce these increases in the plan- ner’s utility: (i) regulation only of money creation: +0.0148; (ii) regulation of both money creation and liquidity: +0.0167; and (iii) regulation of just liquidity: +0.0014. Thus in this example, the benefit of liquidity regulation is approximately one-tenth that which comes from regulating money creation.

V.B. Deposit Insurance and Lender of Last Resort

In the baseline version of the model, the only way for banks to pay off their short-term creditors in the crisis state is by fire- selling their assets, and the only role for policy is to control the amount of short-term debt that is created ex ante. An alternative approach would be for the government totry tostem the amount of socially costly fire sales that occur for a given amount of short-term bank debt. This could be done either with either deposit insurance or a lender-of-last-resort policy.

Unlike in the classic framework of Diamond and Dybvig (1983), such policies are not costless to the government in equi- librium, because here, in the crisis state, there is a probability (1−q) that the banks’ assets will turn out to be entirely worthless. So there is always a chance that taxpayers will be left on the hook. If taxpayer-financed bailouts create deadweight losses, the overall optimum set of policies may have the realistic feature that: (1) some fraction of banks’ money-like claims are insured by the government; (2) the remainder are uninsured, and hence still subject to fire-sale risk; and (3) as before, it makes sense for the regulator to control the total quantity of bank-created money.

To see this explicitly, consider a case where the deadweight costs of taxation take the following form: there is no cost to raising any amount less than L to pay for a bailout, but it is infinitely costly to raise anything more than L. It follows that the amount of government-insured money that can be created, MI, is bounded by MI ≤ L, and it will in fact always be optimal to set MI = L.

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Note, too, that if the government offers insurance on some amount of bank deposits, it will have to put in place a rule to prevent banks from selling all of their assets in a crisis state to satisfy the demands of uninsured depositors; otherwise banks will create just as much uninsured money as before, and the deposit insurer will always be left holding an empty shell in the crisis state. A simple version of such a rule—which can effectively be thought of as a ban on fraudulent conveyance—is a requirement that the fraction of assets sold in a crisis, Δ, not exceed the relative proportion of uninsured deposits. Thus the requirement that goes along with insurance is that Δ≤ M

U

MU +MI , where MU is the quantity

of uninsured money created by the bank. It follows that the total amount of money—insured plus

uninsured—that can be created must satisfy the same collateral constraint as before: M = MU + MI ≤ kλI. The only thing that is changed is the determination of the fire-sale discount k. Since insured depositors are protected and do not need to demand repayment at time 1, only uninsured deposits give rise to fire sales. Thus k is now given by:

(21) 1 k

= g′(W − MU ) = g′(W − M + L).

In other words, the outcome in a world with limited deposit insurance is equivalent to that in a world with no deposit insurance, but where the wealth of the PIs is augmented from W to (W + L). A given amount of total money creation now causes less fire-sale damage, and as a result, more money can be created in equilibrium.

Equation (21) also makes clear the close connection between deposit insurance and a lender-of-last-resort function. Given that the government can never put itself in a position to lose more than L, an alternative to deposit insurance would be for it to leave all deposits uninsured but to commit to step in and invest L alongside the PIs in the event of a fire sale. This would have exactly the same effect—it would reduce the fire-sale discount per equation (21) and thereby allow for more total money creation.

The bottom line is that one can add deposit insurance to the model in such a way as to make it more realistic, without changing any of its qualitative properties. The optimal policy mix will involve limited use of deposit insurance or, equivalently, limited use of a lender-of-last-resort function. Banks will continue to issue uninsured money-like claims alongside insured deposits,

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and hence will continue to create some degree of fire-sale risk. Thus, as before, there will continue to be a motive for regulating the creation of these uninsured short-term claims.

V.C. Regulating the Shadow Banking System

The model also assumes that all private money is manu- factured by commercial banks that are subject to reserve re- quirements. Hence, private money creation can be completely controlled by conventional open market operations. Though this may be an adequate representation of an earlier period in history, it omits an important form of money creation in the modern econ- omy. As Gorton and Metrick (2011) and Gorton (2010) emphasize, private money—in precisely the sense meant here—is alsocreated by the unregulated shadow banking system, via the large volume of short-term claims that are collateralized by securitized loan pools of one form or another.

This observation suggests that commercial banks and shadow banks should be regulated in a symmetric fashion. According to the logic of the model, the ideal way to do this would be to broaden the reach of reserve requirements, so that the cap-and-trade regime covers all the short-term liabilities of both commercial banks and shadow banks. If, due to some political constraint outside the model, the liabilities of shadow banks cannot be subjected to reserve requirements, an alternative approach might be to impose a regime of “haircut” regulation. For example, the central bank could specify the maximum fraction of short-term financing that could be issued against a given amount of collateralizable assets. Moreover, just as the optimal quantity of bank-created money M∗∗ varies with economic conditions, optimal haircuts would respond to these conditions as well. The Appendix provides a brief analysis of haircut regulation. It turns out that although such regulation is indeed useful, it is strictly less efficient than direct control of the quantity of privately created money via, for example, the sort of reserve requirements–based mechanism already outlined.

V.D. Government Debt Maturity

As we have seen, the magnitude of the externality associated with private money creation is related to the bond-money spread (RB − RM ): when the spread widens, the wedge between the social and private returns to money creation goes up. Thus an alternative way to moderate the externality would be to compress

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the spread. In the current version of the model this is impossible— given the assumption of linear preferences, the spread is exoge- nously fixed and insensitive to asset supplies.

However, if one changes the model so that the monetary ser- vices enjoyed by households are a concave function of the supply of money—that is, there is diminishing marginal utility of money— then it becomes possible for the government to act on the bond- money spread. For example, since short-term Treasury bills are riskless, they can provide the same monetary services as short- term bank debt. Hence, an increase in the supply of Treasury bills will, in this modified setting, reduce the bond-money spread.

One appeal of dealing with the externality in this fashion is that unlike some other regulatory approaches, it does not invite evasion. For example, if the scope of reserve requirements were broadened, private actors might try to get around limits on their ability to use short-term debt by using various forms of hidden borrowing, for example, by embedding the borrowing in an opaque derivative contract. In contrast, when the relative cost of short- term borrowing goes up—because the market has been saturated with riskless short-term claims—the incentive to create private money is blunted.

In Greenwood, Hanson, and Stein (2010), we use this obser- vation as the point of departure for a normative theory of govern- ment debt maturity. We argue that the government should choose a shorter debt maturity—and in particular, should issue more riskless T-bills—than it otherwise might, in an active effort to crowd out the short-term debt of financial intermediaries. The ar- gument is based on a principle of comparative advantage. On the one hand, tilting its issuance toward short-term debt is not with- out cost for the government, since with stochastic interest rates this increases the variability of future interest payments and ulti- mately disrupts efforts to smooth tax rates over time. On the other hand, short-term government debt, unlike the short-term debt of financial intermediaries, does not create fire-sale risk. To the extent that the fire-sale externality is more costly to the economy at the margin than the disruption of tax smoothing, it can make sense for the government to take on a bigger role in providing the short-term riskless claims that the economy demands.28

28. To the extent that monetary services reflect an ability to transact between time 0 and 1 without threat of adverse selection, the relevant notion of risk is short-horizon risk—that is, the potential for loss between time 0 and time 1. While long-term Treasuries offer certain ultimate payoffs, they are not riskless over short

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Of course, precisely because of tax-smoothing considerations, it will not generally be optimal for the government to tilt so strongly toward short-maturity issuance as to entirely eliminate the bond-money spread in equilibrium. Rather, optimal behavior by the government on this dimension will typically involve leaving the spread only partially compressed. Although government debt maturity may be one helpful tool in addressing the problem of excessive private money creation, it is not a panacea, and it is unlikely to eliminate the usefulness of the other tools.

V.E. Interest on Reserves

I have thus far assumed that the price level is determined outside the central bank, by the fiscal theory mechanism. Though this is a convenient modeling device, it is not an essential piece of the story. An alternative approach, in the New Keynesian spirit, would be to model prices as being anchored by the central bank’s adherence to a “Taylor rule” (Taylor 1993, 1999) which dictates its path for the short-term nominal rate.

However, this raises a potential problem of there being more objectives than tools. If the short-term nominal rate must satisfy a Taylor rule to maintain price stability, how can it also satisfy equation (18), which specifies its optimal value from a regulatory perspective? One way out of this box is via the payment of interest on reserves (IOR), which many central banks around the world have been doing for years, and which the U.S. Federal Reserve first took up in October 2008. As Goodfriend (2002) points out, with IOR, there are two distinct methods for raising short-term nominal rates: by increasing the interest paid on reserve balances, or by draining reserves from the system, thereby increasing their scarcity value. These methods are not equivalent, because only the latter scarcity-based approach increases the effective “reserves tax” paid by banks, which has been the focus of the foregoing analysis.

Building on this observation, Kashyap and Stein (2012) argue that IOR allows the central bank to simultaneously accomplish two goals: (1) set the short-term nominal rate in accordance with a Taylor rule, and (2) implement an optimal regulatory scheme

horizons if interest rates are stochastic. Hence, they can create adverse-selection problems in trade if one party to a transaction has a better ability to forecast changes in rates than the other.

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of the sort described in this article.29 They note that in a regime with IOR, one can decompose the nominal federal funds rate f as follows:

(22) f = rIOR + ySVR,

where rIOR is the level of interest paid on reserves, and the ySVR is the quantity-mediated scarcity value of reserves. The latter term corresponds exactly to the variable i in equation (18), as it reflects the opportunity cost to a bank of holding reserves.

For example, suppose that an analysis of the sort suggested by equation (18) yields the conclusion that for regulatory pur- poses, the optimal value of i (or equivalently, of ySVR) is 2.0%, whereas an application of the Taylor rule implies that the optimal value of f is 5.0%. In this case, the central bank should set rIOR to 3.0%, and then adjust the quantity of reserves in the system until f equilibrates at 5.0%.

VI. A DISTINCTIVE ACCOUNT OF THE MONETARY TRANSMISSION MECHANISM

Much of the discussion has focused on the normative im- plications of the model. But the model is also of interest as a positive account of the monetary transmission mechanism. Three of its properties are particularly noteworthy in this regard. First, monetary policy has real effects even though all prices are per- fectly flexible. Second, monetary policy works entirely through a quantitative effect on bank lending. That is, the real rates on both money and bonds are fixed and independent of the stance of policy; an easing of policy impacts bank lending only because it enables banks to use more of the former, relatively cheaper funding source. This is a pure version of the bank lending channel, and as such helps explain how monetary policy can have important real effects even when it does not move long-term open market interest rates by much, or when firm investment is not very responsive to such open market rates.

Third, the model has the property that the central bank does not lose control of monetary policy when other, nonreservable forms of money are introduced. Consider what happens if there is, in addition to the risky production technology already in

29. See Woodford (2011) for a more complete treatment of these issues in a dynamic New Keynesian model.

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the model, a safe storage technology. Claims to this technology are riskless, and hence circulate as an alternative transactions medium alongside bank-created money, bearing the same gross interest rate of RM . They are also not subject to reserve requirements. (To be more concrete, one can interpret these claims as money market fund deposits backed by Treasury bills.) Even if the volume of these claims is large, nothing in the model changes. All real rates are already pinned down by the linearity of household preferences and are therefore unaffected by the total quantity of money in circulation.

The distinctive feature of the model in this regard is that the central bank’s ability to influence real outcomes derives not from its control over the total quantity of transactions facilitating claims available to households, but from the fact that it is the unique provider of permits that allow banks to issue short-term debt and hence finance themselves more cheaply. Simply put, only central bank–provided reserves can be used to satisfy the reserve requirements that constrain short-term debt issuance by banks. This “permits” aspect of monetary policy is also emphasized in Stein (1998), though the model in that paper differs significantly on other dimensions.30

VII. CONCLUSIONS

The basic message of this article can be summarized as fol- lows. Banks and other financial intermediaries like to fund them- selves with short-term debt. With sufficient collateral backing it, this short-term debt can be made into riskless money, which, because of the transactions services it generates, represents a cheap source of finance for banks. While society benefits from this private money creation, banks’ private incentives lead them to overdo it, since they do not fully internalize the fire-sales costs that are a by-product of their maturity transformation activities. The externality associated with excessive private money creation provides a fundamental rationale for financial stability regula- tion, and arguably, for the existence of central banks.

In a sufficiently simple institutional environment, the ex- ternality can be addressed with conventional monetary policy,

30. In Stein (1998), reserves are effectively permits that allow banks to access the deposit insurance fund. Because banks face an adverse selection problem in raising uninsured finance, an increase in the quantity of reserves can move lending closer to the first-best level.

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complemented by either deposit insurance or a lender-of-last- resort facility. Indeed, this is one interpretation of what central banks have done for much of their history. In a more realistic modern-day setting, where a substantial shadow banking sector exists alongside traditional commercial banks, other tools, such as expanded reserve requirements, or haircut regulation, may also be necessary. If so, central banks should not be reluctant to deploy these tools—to the extent that they do so in an effort to contain excessive private money creation, they can be said to be pursuing one of their traditional core missions in a more comprehensive and effective manner.

APPENDIX

A. A Variant of the Model with Imperfect Pledgeability

As noted in the text, the result that there is no externality in the low M region when m < mmax is dependent on the assumption that when the PIs invest in real projects, they capture all the social surplus associated with these projects. An alternative approach is to assume that the social return to a project financed by a PI is still given by g(K), but that only ϕg(K) can be pledged to the PI. In this case, the equilibrium determination of k in equation (4) is altered so that 1k = ϕg

′(W − M). Equation (7), the bank’s first-order condition with respect to

m, still holds as stated. If the collateral constraint is not binding, so that η = 0, this condition reduces to:

(23) (RB − RM )− (1 − p)zRM = 0.

However, the planner’s first-order condition for m in equation (12) is now modified, because we can no longer substitute 1k =g

′(W−M). Instead, if ηP = 0 this condition can be written as:

(24) (RB − RM )− (1 − p)zRM − (1 − p)(1 −ϕ)g′(W − M)RM = 0.

Thus even in the low spread region where m < mmax and I = IB, there is now a wedge of (1 − p)(1 − ϕ)g′(W − M)RM

between the private and social first-order conditions. This implies that the optimal price of permits will now be strictly positive in this region. Alternatively, in the monetary policy implementation of the optimum, the nominal interest rate will now be strictly positive for all parameter values.

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Another noteworthy feature of this version of the model is that it implies different comparative statics than the baseline model with respect to the ex ante probability of a financial crisis, as captured by (1 − p). Here, if we are in the low-spread region, an increase in (1 − p) increases the wedge, and hence raises the optimal value of the permit price P, or equivalently, the nominal interest rate. By contrast, in the baseline model with perfect pledgeability, equation (14) says that an increase in (1−p) lowers the desired permit price. Intuitively, the difference is that in the baseline version of the model, banks doa better job of internalizing the social costs of fire sales. Indeed, when the risk of a fire sale goes up, banks become sufficiently more cautious about using short- term debt that they become better aligned with the social planner, which in turn implies that there is less need to rein them in by raising permit prices/interest rates. However, with imperfect pledgeability, there is an effect in the opposite direction, because banks tend to underweight the social costs of fire sales even when the collateral constraint is not binding.

B. Haircut Regulation

To see the effects of haircut regulation most transparently, consider the imperfect pledgeability version of the model just described. Suppose that we are in a “shadow banking” economy where all else is the same as before, with one exception: it is impossible to regulate the absolute quantity of privately created money M directly—say, because shadow banks cannot be sub- jected to reserve requirements—but it is possible to impose a cap mcap < mmax on the fraction of investment that is money financed.

It turns out that this form of haircut regulation, though useful, is a second-best means of intervention as compared to controlling the aggregate quantity of money. This is because the social costs of fire sales are a function of M, so this is the item the planner would ideally like to control. Trying to do this indirectly, by picking a value of mcap, will now have the undesired side effect of encouraging shadow banks to raise their investment above the optimal level of IB. (I assume that we are in the low spread region of the parameter space, so that absent haircut regulation, shadow banks would choose I = IB.) Intuitively, haircut regulation always gives shadow banks the option to create more cheap money financing at the margin, as long as they are willing to raise the level of investment.

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This can be seen formally by considering the first-order con- dition with respect to I for a shadow bank facing binding haircut regulation:

(25) dΠ dI

= pf ′(I)+ (1−p)λ−RB + mcap{(RB−RM )−(1−p)zRM}= 0.

It follows that it is impossible to use haircut regulation to im- plement the social optimum described in equation (24). For if equation (24) is satisfied with I = IB, it must be that (RB − RM )− (1−p)zRM = (1−p)(1−φ)g′(W −M)RM > 0. But then for equation (25) to be satisfied, that is, for the shadow bank to be optimizing given the haircut constraint, we require pf ′(I) + (1−p)λ−RB < 0, which means that I > IB.

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Monetary-and-financial-stability-Here-to-stay-_2006_Journal-of-Banking-Finance.pdf

• Monetary and financial stability: Here to stay?
• Introduction
• The thesis
• The evidence
• Policy implications
• References