NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Optimal Monetary Policy in a Collateralized Economy

Gary Gorton, Ping He

NBER Working Paper No. 22599
Issued in September 2016
NBER Program(s):Asset Pricing, Corporate Finance, Economic Fluctuations and Growth, Monetary Economics

In the last forty or so years the U.S. financial system has morphed from a mostly insured retail deposit-based system into a system with significant amounts of wholesale short-term debt that relies on collateral, and in particular Treasuries, which have a convenience yield. In the new economy the quality of collateral matters: when Treasuries are scarce, the private sector produces (imperfect) substitutes, mortgage-backed and asset-backed securities (MBS). When the ratio of MBS to Treasuries is high, a financial crisis is more likely. The central bank’s open market operations affect the quality of collateral because the bank exchanges cash for Treasuries (one kind of money for another). We analyze optimal central bank policy in this context as a dynamic game between the central bank and private agents. In equilibrium, the central bank sometimes optimally triggers recessions to reduce systemic fragility.

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Document Object Identifier (DOI): 10.3386/w22599

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