Remarks on Unconventional Monetary Policy
Presented at IJCB Conference Hosted by Bank of Japan, September 15, 2010
Lawrence Christiano

1. Introduction
Figure 1 displays the facts that motivates this discussion. Interest rate spreads increased
somewhat at the start of the 2007 recession, and then widened substantially after August
2008. The Federal Reserve initiated a program of unconventional monetary policy in the fallof 2007, by purchasing privately issued assets and by permitting banks to use privately issued
assets as collateral at the discount window. The Fed’s program of unconventional monetary
policy accelerated considerably in March, 2009. At roughly the same time, interest rate
spreads - initially the commercial paper spreads and then corporate spreads - returned tonormal. Moreover, asset prices and economic activity began to bounce back from their plunge
since late 2007 (see Figures 1b and c). These observations raise the following questions:
What are the economic mechanisms whereby unconventional monetary policy has its
impact on interest rate spreads and economic activity?
What are the market failures that unconventional monetary policy is designed to correct?
There is a wide range of actions that a central bank can take as part of an unconventionalmonetary policy. For example, it can make loans to banks, inject equity into banks, purchasevarious kinds of asset backed securities. Answers to the above questions determine which ofthese actions is desired and at what scale.
To address the above questions requires structural models of the economy that capture
the linkages between interest rate spreads and the real economy. Several classic papers laid
the groundwork for this long ago. This is why it is that even though little time has elapsed
since the start of the recent turmoil, there is now a large number of models in place that canbe used to study unconventional monetary policy.1
Broadly, there are three approaches to …nancial frictions. They can be organized aroundthe question, “why are there interest rate spreads?” One answer has to do with liquidity:
an asset that is hard to sell quickly in case the holder suddenly needs cash must pay a highreturn if it is to be held. If everyone comes to think that everyone else is unwilling to partwith cash in exchange for …nancial assets, then there will be a general reluctance to purchaseprivate assets and the liquidity premium on these assets will be high. These considerations
were undoubtedly an important factor behind the rise in spreads in 2008, and it may justify
the Fed’s purchase of private assets at the time.2 Another factor underlying interest rate
spreads is the possibility of non-payment on risky loans. The approach taken in the work of
Carlstrom and Fuerst (1997) and Bernanke, Gertler and Gilchrist (1999) stresses observed
1See, for example, Christiano, Motto and Rostagno (2010), Curdia and Woodford (2009), Dib (2010),
Gertler and Kiyotaki (2010), Hirakata, Sudo and Ueda (2009a,2009b,2010), Meh and Moran (2010), Ueda
(2009) and Zeng (2010).
2
See, e.g., Moore (2009).

costs associated with default.3 However, recent work suggests that the very sharp increases
in spreads in 2008 were too big to be accounted for by observed bankruptcies.4 In part, thismay be due to increased liquidity spreads. However, the moral hazard approach to interest
rate spreads suggests another possibility, that spreads re‡ected a fear of out-of-equilibrium
default.5 In my discussion I present a simple two-period example of this possibility, basedon the paper by Gertler and Kiyotaki (2010) to illustrate this possibility.6

2. Model Analysis
The basic idea in the model is that the people who operate the intermediation industry
come into contact with large sums of money, presenting them with opportunities to ‘steal’.
Stealing need not only mean that bankers literally abscond with money. There are otherways that the same thing can be accomplished. For example, bankers might not make a largee¤ort to manage funds properly (i.e., they ‘steal’leisure) or they might make investments
which do not earn a high return for depositors, but do generate bene…ts for the bankers
themselves. Under these circumstances, depositors are understandably reluctant to makedeposits in banks. They do so anyway if they believe that bankers have committed theirown funds to the industry in a way that if bankers misbehave, the bankers’own funds are
put at risk.7 The idea is that with their own ‘skin in the game’, bankers have an incentive
to behave properly. The funds committed by bankers correspond to their net worth. One
could imagine that in normal times the net worth of the banking system is su¢ cient, so that
depositors have little concern about mismanagement. However, if the net worth of banks
suddenly undergoes a substantial drop (as in 2008), then there may not be enough net worth
in the banking system for depositors to feel comfortable about committing their funds. In
this case, the banking system functions at a lower rate and fewer projects are funded. To
avoid passing up on good projects, unconventional monetary policy - a policy in which thecentral bank takes over part of the intermediation industry - may be desirable and increase
welfare.
We now turn to the formal two-period model. There are many identical households, eachwith a unit measure of members. Some members are ‘bankers’ and others are ‘workers’.
There is perfect insurance inside households, so that all household members consume thesame amount, c; in period 1 and C in period 2. In period 1, workers are endowed with ygoods and the representative household makes a deposit, d; in a bank subject to its period
1 budget constraint (see Table 1).
Bankers in period 1 are endowed with N goods. They take deposits and purchase securities, s; from …rms. Firms issue securities in order to …nance the capital they use to produce
3

The Bernanke, Gertler, Gilchrist (1999) approach has been used to study the …nancial factors driving recent business cycles as well as in the US Great Depression (see Christiano, Motto and Rostagno (2003,2010)).
The approach has been extended to the analysis of risks in the banking system by Dib (2010), Hirakata,
Sudo and Ueda (2009a,2009b,2010), Ueda (2009) and Zeng (2010).
4
See Gilchrist, Yankov and Zakrajšek (2009).
5
Recent work on this includes Gertler and Karadi (2009), Gertler and Kiyotaki (2010), and Meh andMoran (2010).
6
The example is based on ongoing work with Tao Zha.
7
For an example of this idea, see Holmstrom and Tirole (1997).

2

consumption goods in period 2. Intermediation is crucial in this economy. Without it, production cannot occur and period 2 production is the only source of the period 2 consumption
goods. In period 2, households receive earnings, Rd d; on their bank deposits and pro…ts, ;from bankers. The household chooses c; C and d to maximize utility subject to the periods
1 and 2 budget constraints (see Table 1).
Table 1: Problem of the Household
Period 1
Period 2
budget constraint c + d
problem:y

Rd d +

C

maxc;C;d [u (c) + u (C)]

Assuming a constant elasticity period utility function, the solution to the household problem
is given in Table 2.
Table 2: Solution to Household Problem
u0 (c)= Rd
c + RCd = y + Rd
u0 (C)
1u (c) = c1

c=

y+

1+

(

Rd

Rd )
Rd

1

:

We assume that 0 < < 1; so that c is decreasing in Rd and d is increasing in Rd : The
single intertemporal budget constraint in the model is derived by substituting out for d in
the two period budget constraints and imposing that maximizing households will choose a
consumption bundle on the boundary of their budget constraint. According to the intertemporal budget constraint, the present discounted value of consumption must equal the present
discount discounted value of income. As an aside, the expression highlights the fact that
there must be frictions if the purchase of private assets by the government is to have an e¤ect.
For example, suppose the government raises lump sum taxes, T; and uses the proceeds topurchase T securities from …rms. Suppose that the government rebates the proceeds of thisasset purchase in the second period to households in lump sum form and that the government
earns Rd on the private assets. Then, the household’s intertemporal budget constraint is:+ Rd T
C
=
y
T
+
:
Rd
Rd
Note that T cancels in this expression, so that it has no impact on the household’s intertemporal consumption opportunities. As a result, the household’s decisions about c and C areuna¤ected by T: Unless the government’s purchase of private assets corrects some sort ofprivate market failure, it will induce an equal reduction in private purchases and thus haveno e¤ect.
In practice, government intervention has costs that are not included in our model analysis.
For example, it is generally understood that if the Fed purchases too many private assets,
at some point it poses a risk to its independence. Central bank independence is crucial if it
is to succeed in its mission of price stability. Thus, a policy that has no e¤ect in the model
could be very damaging if applied in practice.
We now turn to the banks in our model. We …rst consider the benchmark case in which
there are no …nancial frictions. We suppose that the gross rate of return on privately issuedc+3

securities is technologically …xed at Rk : Bankers combine their own net worth, N; with thedeposits received, d; to purchase securities, s; from …rms. Firms use the proceeds from sellingthese securities to purchase an equal quantity of goods which they turn into capital. The
quantity of goods produced by …rms in period 2 is sRk . Goods producing …rms make no
pro…ts, so sRk is the revenue they pass back to the banks. Banks pay dRd on household
deposits in period 2.
Table 3: Problem of the Bank in the E¢ cient, Benchmark Model
Period 1
Period 2
take deposits, d

pay dRd to households

buy securities, s = N + dreceive sRk from …rms

problem:=maxd sRk

Rd d

An equilibrium for the e¢ cient benchmark version of the model is de…ned in Table 4.
Table 4: De…nition of Equilibrium
Interior Equilibrium: Rd ; c; C; d;such that:(i) the bank, household and …rm problems are solved(ii) markets for goods and deposits clear(iii) c; C; d > 0
A property of equilibrium is that Rd = Rk : To see this, suppose it were not so. If Rd > Rk
the bank would set d = 0 and if Rd < Rk the bank would set d = 1; neither of whichis consistent with the interior equilibria that we study. Thus, in the e¢ cient benchmark
the interest rate faced by households coincides with the actual rate of return on capital. It
is therefore not surprising that the …rst best allocations are achieved in this version of themodel. That is, the allocations in the e¢ cient, benchmark equilibrium coincide with theallocations that solve the following planning problem:8
max u (c) + u (C)c;C;ksubject to:c+ky + N; CkRk :In this economy there is no interest rate spread. This makes sense, since there are no costs
associated with intermediation and there is no default.
Now consider the case of …nancial frictions. The bank has two options. It can choose
not to ‘default’, in which case it simply does what it does in the benchmark version of themodel. In this case, the bank earns pro…ts= Rk (N + d)
8

We assume the environment is such that c < y:

4

Rd d:

Alternatively, the bank can choose to default. In this case it takes a fraction, ; of its assets
and reneges on its commitment to repay depositors. A defaulting bank receives Rk (N + d)
and its depositors receive the rest, (1) Rk (N + d) : The bank chooses the no default
option if, and only if:(N + d) Rk Rd d
(N + d) Rk :(2.1)
Default will never be observed in equilibrium because households would not place deposits
with a bank that has an incentive to default.
When the bank’s incentive constraint, (2.1), is non-binding, then Rk = Rd and the nodefault condition reduces to:
N Rk(N + d) Rk :In an economy in which N is large, the above constraint is likely to be satis…ed. However,
if N is very small (consider, for example, the case, N = 0), then the condition would fail.
In this case, the equilibrium would not be characterized by Rk = Rd : Instead, Rd < Rk ; sothat d would be low. Both the high spread, Rk Rd ; and the low value of deposits, d; would
help ensure that (2.1) is satis…ed.
A sequentially repeated version of this model economy provides a very rough characterization of events before and after 2007. Suppose that N was large in the early period, sothat the economy was operating at its e¢ cient level and no part of actual spreads was dueto the type of default considerations addressed here. Then, in late 2007 the net worth ofbanks suddenly began to fall. Spreads opened up, re‡ecting fears of default. The level ofintermediation dropped and economic activity slowed down. The government responded byusing tax dollars to make loans directly to …rms. This caused spreads to narrow and theeconomy to begin to expand again.

3. Conclusion
Central bank intervention in private asset markets is potentially very costly. In the case of
the US, such interventions have the potential to put the central bank’s independence at risk.
This kind of risk should only be taken if the gains are correspondingly large. Assessing thegains requires models. Such models allow one to decide if intervention is warranted and, if
so, what sort of intervention. Fortunately, there is a range of models under development,each focussing on a di¤erent set of factors driving interest rate spreads. As an illustration,
I brie‡y sketched a very simple model in these remarks. This model has been incorporated
into a full-blown dynamic stochastic equilibrium model usable for policy analysis by Gertler
and Kiyotaki (2010).

5References[1] Carlstrom, Charles T., and Timothy Fuerst, 1997, “Agency Costs, Net Worth and Business Fluctuations: A Computable General Equilibrium Analysis,”American Economic
Review 87, 893-910.
[2] Christiano, Lawrence J., Roberto Motto and Massimo Rostagno, 2003, “The Great Depression and the Friedman-Schwartz Hypothesis,”Journal of Money, Credit and Banking, Vol. 35, No. 6 (December, Part 2)[3] Christiano, Lawrence J., Roberto Motto and Massimo Rostagno, 2010, “Financial Factors in Business Cycles,”manuscript, European Central Bank.
[4] Curdia, V. and Michael Woodford, 2009, “Credit Frictions and Optimal Monetary Policy,”BIS Working Papers, 278.
[5] Dib, Ali, 2010, “Capital Requirement and Financial Frictions in Banking: Macroeconomic Implication,”manuscript, Bank of Canada, August 28.
[6] Gertler, Mark and Peter Karadi, 2009,“A Model of Unconventional Monetary Policy,”
manuscript, New York University.
[7] Gertler, Mark, and Nobuhiro Kiyotaki, 2010, “Financial intermediation and credit policy in business cycle analysis," forthcoming chapter in Handbook of Monetary Economics, edited by Friedman and Woodford.
[8] Gilchrist, Simon, Vladimir Yankov and Egon Zakrajšek, 2009, “Credit Market Shocks
and Economic Fluctuations: Evidence from Corporate Bond and Stock Markets,”Journal of Monetary Economics, Volume 56, Issue 4, May, Pages 471-493.
[9] Hirakata, Naohisa, Nao Sudo and Kozo Ueda, 2009a, “Chained Credit Contracts andFinancial Accelerators,”Discussion Paper Series E-30, Bank of Japan.
[10] Hirakata, Naohisa, Nao Sudo and Kozo Ueda, 2009b, “Capital Injection, Monetary
Policy, and Financial Accelerators,”manuscript, Bank of Japan, October 16.
[11] Hirakata, Naohisa, Nao Sudo and Kozo Ueda, 2010, “Do Banking Shocks Matter for
the U.S. Economy?”manuscript, Bank of Japan.
[12] Holmstrom, Bengt and Jean Tirole, 1997, “Financial Intermediation, Loanable Funds,
and the Real Sector,” The Quarterly Journal of Economics, Vol. 112, No. 3. (August),
pp. 663-691.
[13] Meh, Cesaire and Kevin Moran, 2010, “The Role of Bank Capital in the Propagationof Shocks,”Journal of Economic Dynamics and Control, 34: 555-76.
[14] Moore, John, 2009, “Contagious Illiquidity,”plenary lecture, joint conference, the XIVAnnual Meeting of the Latin American and Caribbean Economic Association, and the
XXV Latin American Meeting of the Econometric Society, October 1-3.
6

[15] Ueda, Kozo, 2009, “Banking Globalization and International Business Cycles,” manuscript, Bank of Japan, December 20.
[16] Zeng, Zhixiong, 2010, “A Theory of the Non-Neutrality of Money with Banking Frictions
and Bank Recapitalization,”manuscript, Monash University, July.

7

Figure 1a: Spreads, 3‐month commercial paper (CP) over Tbills and BAA versus AAA corporate bonds
3

CP, financial firms
October, 2007
March, 2009
August, 2008
CP, nonfinancial firms
BAA-AAA

2.5
2
1.5
1
0.5

2007

2007.5

2008

2008.52009

2009.520102010.5Figure 1c: Output

Figure 1b: Stock Market
1600
4.6
1500
1400
1300

S&P 500
October, 2007
March, 2009
August, 2008

log, industrial production
October, 2007
March, 2009
August, 2008

4.55

1200
1100
1000

4.5

900
800
2007 2007.5 2008 2008.5 2009 2009.5 2010 2010.5

4.452007 2007.5 2008 2008.5 2009 2009.5 2010 2010.5