Unconventional Monetary Policy, Liquidity Risk, and Credit Market Activity

Abstract

Recently, central banks around the world have relied mostly on nontraditional policy tools to stimulate economic activity. A distinctive example is the expansion of the size of central bank balance sheets through the purchase of long-term government securities. In this paper we analyze the e⁄ect on credit markets of this unconventional monetary policy tool and compare it with that of conventional instruments such as purchases of short-term government debt. Our framework takes into account the role of nancial intermediaries that provide risk-sharing and intertemporal consumption-smoothing services in the transmission mechanism of monetary policy. Our ndings suggest that central bank purchases of long-term government securities stimulate credit market activity and reduce the cost of public and private borrowing only under a low interest rate and reduced scal debt regime. Otherwise, this policy increases the cost of servicing debt resulting in a contraction of lending. In contrast, short-term government debt purchases aid credit availability but negatively a⁄ect the amount of risk-sharing in the economy.

Keywords: Balance Sheet Policy, Long-Term Asset Purchases, Liquidity Risk, Financial Intermediation, Monetary policy