Unconventional credit policy in an economy under zero lower bound

This paper was produced as part of the BIS Consultative Council for the Americas (CCA) research conference on The economics of the Covid-19 pandemic.

Summary

Focus

What is the impact of unconventional credit policy in a zero lower bound environment? We study the effectiveness of unconventional credit policy once the economy reaches the zero lower bound and whether this policy can make it less likely that the economy will reach the zero lower bound.

Contribution

The zero lower bound in the monetary policy rate was an important constraint faced by several central banks during the Covid-19 global shock. However, monetary policy now includes unconventional measures, such as liquidity facilities or government-guaranteed corporate lending. In this context, our contribution is to uncover the implications and limitations of unconventional credit policy in a zero lower bound environment. The unconventional credit policy entails central bank liquidity injections into banks in exchange for their commitment to use these resources to make government-guaranteed loans. Our findings show the various ways that unconventional credit policies influence credit supply and demand frictions.

Findings

We find that unconventional credit policy can partially undo the effects of credit frictions and prevents the economy from reaching the zero lower bound. Since bank loans, funded with central bank liquidity, cannot be diverted by banks and are government-guaranteed, credit policy increases credit supply and credit demand. In addition, once the economy reaches the zero lower bound, the effect of unconventional credit policy is reduced because a constrained monetary policy to stabilise inflation exacerbates financial frictions and significantly reduces entrepreneurs' incentives to demand bank loans.

Abstract

In this paper we develop a simple two-period model that reconciles credit demand and supply frictions. In this stylized but realistic model credit and deposit markets are interlinked and credit demand and credit supply frictions amplify each other in such a way that produces in equilibrium inefficiently low levels of credit and stronger reductions of the real and nominal interest rates, so an economy is much closer to the ZLB. However, an unconventional credit policy, that consists on central bank liquidity injection to banks provided they commit to issue loans (indirect central bank loans) that are guaranteed by the government, can undo partially the effects of the credit frictions and prevents the economy from reaching the ZLB. Since indirect central bank (CB) loans cannot be diverted by banks and are governmentguaranteed, credit market interventions rise aggregate credit supply and positively affect the aggregate credit demand, respectively. However, once the economy is at the ZLB the effect of a credit policy is reduced due to a relatively stronger inflation reduction, which in turn reduces entrepreneurs' incentives to demand bank loans, and due to that the relative cost reduction from having access to cheaper indirect CB loans is smaller.

JEL classification: E44, E5, G21, G28.

Keywords: unconventional credit policy, asymmetric information, moral hazard, zero lower bound.