The Interaction between the Central Bank and Government in Tail Risk Scenarios
21 Pages Posted: 19 Oct 2012 Last revised: 27 Mar 2013
Date Written: March 25, 2013
We analyse the relationship between tail risk and crisis measures by governments and the central bank. Using an adjusted Merton model in a game theoretical set-up, the analysis shows that the participation constraint for interventions by the central bank and the governments is less binding if the risk of contagion is high. The strategic interaction between governments and the central bank also influences the effectiveness of the interventions. A joint effort of both the governments and central bank leads to a better outcome. To prevent a bad equilibrium a sizable commitment by both players is required. Our stylized model sheds light on the strategic interaction between EMU governments and the Eurosystem in the context of the Outright Monetary Transactions program (OMT).
Keywords: Financial crisis, Monetary policy, Central banks, Policy coordination
JEL Classification: E42, E52, E61, G01, G18
Suggested Citation: Suggested Citation