Title: An Empirical and Theoretical Analysis of Nonlinear Public Policies
- David Aikman, Professor, King’s College, London
- Martial Dupaigne, Professor, University of Montpellier
- Patrick Fève, Professor, University of Toulouse 1 Capitole - TSE
- Fabrice Collard, CNRS Senior Researcher, University of Toulouse 1 Capitole - TSE
- Franck Portier, Professor, University College London
The first chapter of my PhD thesis is titled “Financial Frictions and Asymmetric Monetary Policy Passthrough in India”. In this research work, I use panel data on Indian banks to compute the response of deposit rates to monetary policy surprises and find that the interest rate pass through is incomplete, highly asymmetric and subject to liquidity conditions, both at the individual and aggregate (systemic) level. The interest rate response is higher for an increase (as compared to a decrease) in policy rate which implies a downward rigidity of interest rates. I document a novel mechanism through which liquidity conditions influence monetary policy transmission to banks. Aggregate liquidity deficit aggravates the asymmetry in the interest rate pass through. On the other hand, proportion of liquid assets held by banks mitigates the asymmetry. Higher liquid investments enable banks to lower the deposit rates more effectively in response to a policy rate cut. I explain the empirical findings using a model where banks face an occasionally binding collateral constraint, penalty costs and a bid-ask spread while borrowing funds from the central bank. The model highlights the role of financial frictions, institutional factors, prudential regulation and aggregate liquidity conditions in the transmission of monetary policy.
The second chapter is titled “Macroprudential Policy Interactions in a Sectoral DSGE Model with Staggered Interest Rates”. In this work with economists at the Bank of England, we develop a two-sector DSGE model with a detailed banking sector along the lines of Clerc et al. (2015) to assess the impact of macroprudential tools (minimum, countercyclical and sectoral capital requirements, as well as a loan-to-value limit) on key macroeconomic and financial variables. The banking sector features residential mortgages and corporate lending subject to staggered interest rates à la Calvo (1983), which is motivated by the sluggish movement of lending rates due to fixed interest rate loan contracts. Other distortions in the model include limited liability, bankruptcy costs and penalty costs for deviations from regulatory capital. We estimate the model using Bayesian methods based on quarterly U.K. data over 1998Q1-2016Q2. Our contributions are threefold. We show that: (i) coordination of macroprudential tools may have a welfare-improving effect, (ii) macroprudential tools would have improved some macroeconomic indicators but, within our model, not have prevented the Global Financial Crisis, (iii) staggered interest rates may alter the transmission of macroprudential tools that work through interest rates.
The third chapter is titled “Central Bank Digital Currency and Financial Stability”. This paper studies the potential impact of introducing central bank digital currency (CBDC) on bank liquidity risk and financial stability. I develop a model with nominal deposit contracts augmented with a cash in advance constraint which makes the banking system vulnerable to runs. Banks can generate inside money but have limited access to outside money or cash. The central bank does not face this limitation as it has monopoly over the issue to fiat currency. An appropriately designed CBDC mechanism, where depositors hold deposits at the central bank and the central bank lends directly to banks, has the potential to enhance financial stability as it can prevent self-fulfilling runs on banks/central bank while providing liquidity services to depositors. The fourth chapter is titled “Central Bank Digital Currency, Deposit Insurance and Capital Regulation”. This paper studies the potential impact of introducing central bank digital currency (CBDC) on financial stability, deposit insurance and prudential capital regulation. I incorporate CBDC in the framework developed in Allen et al. (2015). The model features financial market segmentation, bank default risk and bankruptcy costs, which determine the socially optimal level of bank capital. Under-priced deposit insurance creates a distortion whereby banks do not fully internalize the bankruptcy costs associated with bank defaults and end up raising sub-optimally lower level of capital. The model suggests that CBDC mechanism, wherein depositors hold deposits at the central bank and the central bank lends directly to banks, emerges as a substitute for deposit insurance, while avoiding distortions associated with the latter. CBDC would enable central banks to use interest rate as a tool for implementing prudential policy. CBDC has the potential to enhance financial stability as it can (a) provide risk free return to depositors (through diversification benefits) by pooling credit risk of the entire banking system (b) provide incentives to banks to raise optimal amount of capital and avoid excessive systemic risk taking, thereby lower the need for prudential capital regulation.