Conventional and Unconventional Monetary Policy with Endogenous Collateral Constraints∗ Alóısio Araújo IMPA and EPGE-FGV

We consider the effects of central-bank purchases of a risky asset, financed by issuing riskless nominal liabilities (reserves), as an additional dimension of policy alongside “conventional” monetary policy (central-bank control of the riskless nominal interest rate), in a general-equilibrium model of asset pricing and risk sharing with endogenous collateral constraints of the kind proposed by Geanakoplos (1997). When sufficient collateral exists for collateral constraints not to bind for any agents, we show that central-bank asset purchases have no effects on either real or nominal variables, despite the differing risk characteristics of the assets purchased and the ones issued to finance these purchases. At the same time, the existence of collateral constraints allows our model to capture the common view that large enough central-bank purchases would eventually have to effect asset prices. But even when central-bank purchases raise the price of the asset, owing to binding collateral constraints, the effects need not be the ones commonly assumed. We show that under some circumstances, central-bank purchases relax financial constraints, increase aggregate demand, and may even achieve a Pareto improvement; but in other cases, they may tighten financial constraints, reduce aggregate demand, and lower welfare. The latter case is almost certain the one that arises if central-bank purchases are sufficiently large. ∗We thank Kyle Jurado and Savitar Sundaresan for research assistance, and participants at presentations at IMPA, MIT, and the Cowles Foundation Conference on General Equilibrium and its Applications for helpful comments. We also acknowledge financial support from CAPES-PNPD and IMPA (Schommer), and the NSF under grant SES-0820438 (Woodford). One of the more notable developments in central banking since the global financial crisis has been an increase in the diversity of types of market transactions through which central banks have sought to influence financial conditions. Before the crisis, it had become common to think of monetary policy as a uni-dimensional decision: the periodic reconsideration of the central bank’s operating target for a single, shortterm (typically overnight) nominal interest rate. Over the past five years, instead, a number of leading central banks (including the Federal Reserve, the Bank of Japan, and the Bank of England) have made almost no changes in their policy rates — having taken those rates to levels viewed as their effective lower bounds by the beginning of 2009, while additional monetary easing continued to be desired — yet have been quite active on other dimensions, making dramatic changes in both the size and composition of their balance sheets. While the theoretical literature on the effects of changes in interest-rate policy, and on the way in which variations in the supply of bank reserves and adjustment of the rate of interest paid on reserves allow central banks effective control of short-term interest rates, is well-developed, much less is understood about the effects that should follow from variations in the central bank’s balance sheet apart from those involved in implementing interest-rate policy. On one traditional view, the assets held by the central bank to “back” its issuance of monetary liabilities are of little macroeconomic significance — only the quantity of reserves created should matter, and that only because of its implications for the determination of short-term interest rates. There would then be little reason to conceive of multi-dimensional monetary policy options. On an alternative view, the asset-purchase programs recently implemented by central banks are simply a variant of what monetary policy has always been about: central banks exchanging one type of financial instrument for another, so as to influence market rates of return. On this view, there are naturally multiple possible dimensions of policy to the extent that there are multiple interest rates — as there naturally are, given the different risk characteristics of different instruments. Here we undertake a theoretical analysis of the effects of alternative dimensions of monetary policy, in a general-equilibrium asset-pricing framework in which assets with different risk characteristics co-exist and earn different rates of return in equilibrium. We introduce a central bank with effective control over short-term nominal interest rates, that can determine the general level of prices (of goods and services in terms of money) through this “conventional” monetary policy; but we also allow the central to engage in open-market purchases and sales of the various types of assets with differing