Working Papers

We provide a theory for the collapse in bank-to-bank trade experienced in the United States since the 2007-2009 financial crisis and since the onset of a floor system for monetary policy. We show that the choice of framework to implement monetary policy affects welfare, and that interbank trade is not feasible under a floor system.  Our theory incorporates a key feature of the Federal Funds market: credit is unsecured and, thus, subject to an endogenous borrowing limit. When the punishment for failing to repay loans is permanent exclusion from interbank markets, if interest rates are too low, then the opportunity cost of holding money is also low, and so is the punishment for defaulting on loans. Hence borrowing banks have no incentive to repay their loans, the endogenous borrowing limit is zero and bank-to-bank lending collapses, despite banks still having a need to borrow. We propose a framework of Voluntary Reserve Targets to implement monetary policy that restores an active interbank market, and we provide conditions for it to be welfare improving over a simple reserve remuneration framework, even away from the floor.


This paper combines the idea that securities should be information insensitive in order to be liquid, with the idea that an infrastructure which performs clearing of trades, and offers additional services to the counterparties, facilitates securities to be liquid. In a recent paper, Gorton et al. argue that securities that serve as a transaction medium should be the least information-sensitive, and derive sufficient conditions for such security to be debt. Also, a few recent papers (Acharya and Bisin, Duffie and Zhu and Koeppl and Monnet among others) emphasize the role of a Central Counterparty (CCP) in internalizing externalities that stem from the opacity of over-the-counter (OTC) transactions, therefore achieving the efficient level of trade, and the role of a CCP in providing the participants with insurance and cost effective clearing services. This paper develops a framework very similar to Gorton et al., modified to analyze some of the functions that a CCP performs. It shows that for any type of security, regardless of whether it is debt or equity, clearing transactions through a CCP reduces the extent to which securities are information-sensitive. Two functions of a CCP are key: multilateral netting and the existence of a default fund. By reducing the exposure of each counterparty to one another (or to the CCP), both netting and the default fund reduce the incentives of traders to acquire information about the payoffs of the security they are trading.  A role of CCPs that has been identified by policy makers as fostering liquidity and stability of OTC transactions, is to perform margin calls to adjust the available collateral posted for each participant's net position, following the marking to market of securities. In this framework, however, the perception that margin calls foster liquidity is incorrect: traders have even more incentives to acquire information about the securities' payoff so that fewer transactions, which would be welfare improving, are carried out.


This paper develops a framework to study the interaction between banking, price dynamics, and monetary policy. Deposit contracts are written in nominal terms: if prices unexpectedly fall, the real value of banks' existing obligations increases. Banks default, a panic precipitates and economic activity declines. If banks default, aggregate demand for cash increases because financial intermediation provided by banks disappears. With the stock of money supply unchanged, the price level drops, thereby providing incentives for banks to default. Active monetary policy prevents banks from failing and output from falling. Deposit insurance can achieve the same goal but amplifies business cycle fluctuations by inducing moral hazard.