Ester Faia

Monetary Policy and Risk Taking

We assess the effects of monetary policy on bank risk to verify the existence of a risk-taking channel – monetary expansions inducing banks to assume more risk. We first present VAR evidence confirming that this channel exists and is particularly significant on the bank funding side. Then, to rationalize this evidence we build a macroeconomic model where banks subject to runs endogenously choose their funding structure (deposits vs. capital) and risk level. A monetary expansion increases bank leverage and risk. In turn, higher bank risk in steady state increases asset price volatility and reduces equilibrium output.

Optimal Monetary Policy Rules, Asset Prices and Credit Frictions

We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the ‘financial markup’ (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behaviour of inflation relative to its credit-frictionless level. Thus neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy.

Union Power, Collective Bargaining, and Optimal Monetary Policy

We study the design of optimal monetary policy (Ramsey policies) in a model with sticky prices and unionized labour markets. Collective wage bargaining and unions monopoly power tend to dampen wage fluctuations and to amplify employment fluctuations relatively to a DNK model with walrasian labour markets. The optimal monetary policy must trade-off counteracting forces. On the one side deviations from zero inflation allow the policy maker to smooth inefficient employment fluctuations. On other side, the presence of wage mark-ups and wage stickiness produce inflationary pressures that require aggressive inflation targeting. Overall we find that the Ramsey planner deviates from full price stability and that an optimal rule targets inflation the real economic activity alongside inflation.

RAMSEY MONETARY POLICY WITH CAPITAL ACCUMULATION AND NOMINAL RIGIDITIES

Recent literature on the design of optimal monetary policy has shown that deviations from price stability are small whenever prices are sticky. This paper reconsiders this issue by introducing capital accumulation in the model. Optimal monetary policy in this setup implies small deviations from price stability. The monetary authority optimally uses inflation as an explicit tax on monopolistic profits to reduce the price markup across states. Variable markup is achieved in this setup because the share of investment demand over output varies across states and in response to TFP shocks.

Fiscal Calculus and the Labor Market

The endorsement of expansionary fiscal packages has often been based on the idea that large multipliers can counteract rising and persistent unemployment. We explore the effectiveness of fiscal stimuli in a model with matching frictions and endogenous participation. Results show that hiring subsidies, contrary to increase in government spending, deliver large multipliers, even with distortionary taxation. Those policies increase the incentives to post vacancies, hence employment. Furthermore, by reducing marginal costs they also reduce inflation and increase private consumption.

Macroeconomic and Welfare Implications of Financial Globalization

It is well documented that since the mid-1980s there has been a surge in capital flows due to an increased integration of world financial markets. Absent limited commitment, the increase in financial linkages should improve risk-sharing opportunities and foster consumption smoothing. However the data show that for several countries financial liberalization leads to enhanced consumption volatility. This fact can be rationalized using a small open economy model where foreign lending to households is constrained by a borrowing limit motivated by limited enforcement. Borrowing is secured by collateral in the form of durable investment whose accumulation is subject to adjustment costs. In this economy an increase in the degree of capital account liberalization increases consumption volatility (even relative to output volatility) as agents are unable to exploit risk-sharing opportunities. In presence of risk-averse agents an increase in financial integration reduces welfare.

Cross-Border Resolution of Global Banks ∗

Most recent regulations establish that resolution of global banking groups shall be done according to bail-in procedures and following a Single Point of Entry (SPE) as opposed to a Multiple Point of Entry (MPE) approach. The latter requires parent holding of global groups to put up front the equity capital needed to absorb losses possibly emerging in foreign subsidiaries-branches. No model rationalized so far such resolution regime. We build a model of optimal design of resolution regimes and compare three regimes: SPE with cooperative authorities, SPE with non-cooperative authorities and MPE (ring-fencing). We find that the costs for bondholders of bail-inable instruments is generally higher under noncooperative regimes and ring-fencing. We also find that in those cases banks have ex ante incentives to reduce their exposure in foreign assets. We also examine recent case studies that help us rationalize the model results.

Financial regulation : a transatlantic perspective

Part I. Micro- and Macroprudential Regulation: 1. The road from micro-prudential to macro-prudential regulation Ester Faia and Isabel Schnabel 2. Lessons from the European financial crisis Marco Pagano 3. Bank stress tests as a policy tool: the European experience during the crisis Athanasios Orphanides 4. Monetary policy in a Banking Union Frank Smets and Tobias Linzert 5. Competition and state aid rules in the time of Banking Union Ignazio Angeloni and Niall Lenihan 6. Bail-in clauses Jan Pieter Krahnen and Laura Moretti 7. Shadow resolutions as a no-no in a Sound Banking Union Gerard Hertig and Luca Enriques 8. A political economy perspective on common supervision in the Eurozone Tobias Troger Part II. Investor and Borrower Protection: 9. Keeping households out of financial trouble Michael Haliassos 10. Financial market governance and consumer protection in the EU Niamh Moloney 11. Financial advice Andreas Hackethal 12. Regulation of financial institutions in the United States Howell Jackson 13. Risk aversion and financial crisis Luigi Guiso 14. Household finance and the law - a case study on economic transplants Katja Langenbucher.

RETHINKING OPTIMAL EXCHANGE RATE REGIMES WITH FRICTIONAL LABOR MARKETS

Currency fluctuations are an important determinant of labor market dynamics. Vice versa, relative labor costs affect real exchange rate dynamics. The optimal choice of exchange rate regimes cannot neglect this nexus. We assess such a choice using a two-country model with frictional labor markets. The monetary authority faces a tension between the classical insulating property of floating exchange rates and the destabilizing effects of currency fluctuations on (relative) job flows. Results show that the second motive is important: optimal monetary policy prescribes (some) response to the exchange rate. We also reexamine the conditions for optimal policy in a currency area whose members experience asymmetries in labor market institutions.

Welfare Implications of Capital Account Liberalization

In recent decades, capital account liberalization in emerging economies has often been followed by a surge in capital inflows, despite the presence of severe informational asymmetries for foreign lenders. Empirical studies have shown that in emerging economies financial liberalization has led to an increase in consumption volatility (also relative to output). I use a small open economy model where foreign lending to households is constrained by an endogenous borrowing limit. Borrowing is secured by collateral in the form of durable investment whose accumulation is subject to adjustment costs. This economy is able to replicate the aforementioned stylized fact in response to various shocks (productivity, foreign demand and government expenditure). I find that financial liberalization reduces welfare since it increases the volatility of consumption and employment.