Collateral Amplification Under Complete Markets

31 Pages Posted: 16 Aug 2014

Date Written: July 31, 2014

Abstract

This paper examines the robustness of the Kiyotaki-Moore collateral amplification mechanism to the existence of complete markets for aggregate risk. We show that, when borrowers can hedge against aggregate shocks at fair prices, the volatility of endogenous variables becomes identical to the first best in the absence of credit constraints. The collateral amplification mechanism disappears. To motivate the limited use of contingent contracts, we introduce costs of issuing contingent debt and calibrate them to match the liquidity and safety premia the data. We find that realistic costs of state contingent market participation can rationalize the predominant use of uncontingent debt. Amplification is restored in such an environment.

Keywords: collateral constraints, amplification

JEL Classification: E32, D52

Suggested Citation

Nikolov, Kalin, Collateral Amplification Under Complete Markets (July 31, 2014). ECB Working Paper No. 1716, Available at SSRN: https://ssrn.com/abstract=2474683

Kalin Nikolov (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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