We study optimal monetary policy in an analytically tractable New Keynesian DSGE-model with an emission externality. Empirically, emissions are strongly pro-cyclical and output in the flexible price equilibrium overreacts to productivity shocks, relative to the efficient allocation. At the same time, output under-reacts relative to the flexible price allocation due to sticky prices. Therefore, it is not optimal to simultaneously stabilize inflation and to close the natural output gap, even though this would be feasible. Real externalities affect the LQ-approximation to optimal monetary policy and we extend the analysis of Benigno and Woodford (2005) to inefficient flexible price equilibria. For central banks with a dual mandate, optimal monetary policy places a larger weight on output stabilization and targets a non-zero natural output gap, implying a higher optimal inflation volatility.
How does convenience yield interact with sovereign risk and the supply of government bonds? We propose a model of sovereign debt and default in which convenience yield arises because investors are able to pledge government bonds as collateral on financial markets. Consistent with euro area data convenience yield is large if government bonds are (i) scarce due to investors' high collateral valuation or (ii) safe due to a small collateral haircut being applied to them. Calibrating the model to the data, we demonstrate that convenience yield improves the fit of sovereign default models to developed economy bond market data, contributes substantially to the public debt-to-GDP ratio, and rationalises prolonged periods of negative bond spreads -- even in the presence of default risk. A large debt elasticity of investors' collateral valuation is key to these results. In this setting, highly debt-elastic collateral haircuts exacerbate collateral scarcity in crisis times, raising government bond prices and eroding fiscal discipline.
This paper proposes a quantitative multi-sector DSGE model with bank failure and firm default to study the interactions between bank regulation and climate policy. Households value the liquidity of deposits, which are protected by deposit insurance. Banks collect deposits and issue equity to extend defaultable loans to clean and fossil energy firms. Bank capital regulation affects liquidity provision to households, bank risk-taking, and loan supply across sectors. Using a calibrated version of the model, we obtain four results: first, fossil penalizing capital requirements can be discarded as climate policy instrument, since their effect on sector-specific investment is quantitatively negligible in general equilibrium. Second, Ramsey-optimal capital requirements in response to a tax-induced clean transition decline to counteract negative loan demand effects. Third, differentiated capital requirements are only necessary if banks are not perfectly diversified across sectors. Fourth, nominal rigidities induce a temporary tightening of capital requirements if the transition is inflationary and, thus, spurs a boom on the loan market.
This paper proposes a quantitative DSGE model with financial and environmental frictions to asses how the transition to net zero emissions affects central bank collateral policy, which specifies the assets that banks can pledge to obtain central bank funding. Climate policy affects macroeconomic outcomes that are relevant for the (optimal) conduct of central bank collateral policy. In the short run, high emission taxes increase default rates in the non-financial sector. In the longer run, they reduce the return on investment, loan demand by non-financial firms and, hence, the amount of collateral available to banks. Welfare-maximizing collateral policy is temporarily tight in response to positive emission tax shocks in order to reduce the central bank's exposure to risky collateral. By contrast, it is structurally more lenient in the longer run in order to counteract negative effects of emission taxes on collateral availability.
How does a shock to the liquidity of bank assets affect credit supply, cross-border lending, and real activity at the firm level? We exploit that, in 2007, the European Central Bank replaced national collateral frameworks by a single list. This collateral framework shock added loans to non-domestic euro area firms to the pool of eligible assets. Using loan level data, we show that banks holding a large share of newly eligible cross-border loans increase loan supply by 14% and reduce spreads by 16 basis points, compared to banks with smaller holdings of such loans. The additional credit is mainly extended to (previously eligible) domestic borrowers, suggesting only a limited cross-border effect of the collateral framework shock. However, the shock had real effects: firms highly exposed to affected banks increase their total debt, employment, and investment.
How does a shift to ambitious climate policy affect financial stability? We develop a quantitative macroeconomic model with carbon taxes and endogenous financial crises to study so-called “Climate Minsky Moments”. By reducing asset returns, an accelerated transition to net zero initially elevates the crisis probability substantially. However, carbon taxes enhance long-run financial stability by diminishing the relative size of the financial sector. Quantitatively, the net financial stability effect is only negative for higher social discount rates. Even then, the welfare effects of “Climate Minsky Moments” are, at most, second-order relative to the real costs and benefits of an accelerated transition.
This paper shows how credit constraints at the firm level affect the conduct of climate policy. Using a large international panel of listed firms, this paper empirically demonstrates that firms with tighter credit constraints, measured by their distance-to-default, exhibit a smaller emission reduction after a carbon tax increase than their less constrained peers. We incorporate this channel into a quantitative E-DSGE model with credit frictions that depend on structural parameters and give rise to endogenous credit constraints. In the model, increasing the severity of credit frictions is associated with a tightening of credit constraints and an increase of the default probability. We show analytically that more severe credit frictions reduce the incentives to invest into emission abatement, since shareholders are less likely to receive the payoff from such an investment. In a calibrated of the model, we find that increasing the severity of credit frictions to such a degree that the default probability increases by 2 percentage points substantially impairs climate policy. In this case, carbon taxes have to be almost 8 dollars per tonne of carbon larger in order to remain consistent with net zero.
Abstract: This paper studies the effects of making corporate sector assets eligible as collateral for central bank borrowing. Banks are willing to pay collateral premia on assets if they become eligible as collateral. Collateral premia make debt financing cheaper for eligible firms, which respond by increasing their debt issuance. While this has a positive effect on collateral supply, firm responses also have a negative effect: higher debt issuance makes corporate bonds riskier in future periods, which in turn reduces aggregate collateral. We provide a novel analytical characterization of firm responses to eligibility requirements in a heterogeneous firm model with default risk and collateral premia paid on eligible bonds. Using a calibration of the model to euro area data, we study the impact of the ECB's collateral easing policy during the 2008 financial crisis and evaluate the quantitative relevance of firm responses. We find that firm responses substantially deteriorate collateral quality and dampen the total increase of collateral supply. Our analysis suggests that a covenant conditioning eligibility on leverage and current default risk is a potentially powerful instrument to mitigate the adverse impact of collateral premia on default risk and, thereby, to maintain a high level of collateral supply.
The European debt crisis of 2011 has been characterized by an unprecedented divergence in borrowing costs for euro area members. While 'peripheral' government bond yields increased to unprecedented levels, yields on German and other 'core' bonds strongly declined, even though German CDS-spreads reached an all-time high in 2011. To reconcile this flight-to-quality, I propose a model of a financially integrated monetary union in which heterogeneous sovereign borrowers issue bonds subject to default risk. Investors value the collateral service of government bonds, which decreases in haircuts that are specified by the central bank in its collateral framework. In a union-wide fiscal crisis, larger haircuts on all borrowers imply a contraction of aggregate collateral supply. This makes the collateral service of the safest available bonds more valuable to investors: yields on relatively safe bonds decline, even though their default risk increases. At the same time, the loss of collateral premia further increases the yields of riskier government bonds. Using the model, I show that a full backstop policy accepting all bonds during a fiscal crisis with zero haircuts reduces the dispersion of government bond spreads and reduces sovereign risk in the monetary union.