Nontraditional Monetary Policy in a Model of Default Risks and Collateral in the Absence of Commitment

Abstract

We show that a central bank could improve the allocation of resources by delivering the defaulting party’s collateral goods to those who consume the most quickly. We base our discussion on Mills and Reed (2012)’s repo contract model, which shows that the consumption of the lender will be the same whether the borrower is a productive agent or an unproductive agent. We extend their model by considering shocks to the second period of lenders’ lives, which force them to consume within an early stage of the second period of their lives. The shock could make the consumption of lenders vary depending on the timing of transactions in the goods market. We show that a central bank could make the consumption of lenders constant regardless of the timing of transactions in the goods market, and could achieve better resource allocation by using various nontraditional monetary policy tools.

Keywords: : collateral, contract, repurchase agreement, nontraditional monetary policy

JEL Classification: E44, E58