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The Chicago Plan Revisited

The Chicago Plan Revisited

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Published by Steve B. Salonga

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Published by: Steve B. Salonga on Nov 03, 2012
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Almost identical forms of the borrowing problem are solved by constrained households (for
consumer and mortgage loans), manufacturers and capital investment funds. In this
subsection we again use general notation, with x ∈ {c,a,m,k} representing the four
different types of loans. Borrowers use an optimally chosen combination of nominal/real
bank loans Lx


t(j) and internal funds to purchase nominal/real assets Xt/xt. The
ex-post nominal/real returns on the latter are denoted by Retx,t and retx,t.

After the asset purchase each borrower of type x draws an idiosyncratic shock which
changes xt(j) to ωx

t+1xt(j) at the beginning of period t+ 1, where ωx

t+1 is a unit mean
lognormal random variable distributed independently over time and across borrowers of
type x. The standard deviation of ln(ωx

t+1), Sz


t+1, is itself a stochastic process that
will play a key role in our analysis. We will refer to this as the borrower riskiness shock. It
has an aggregate component Sz

t+1 that is common across borrower types, and a

type-specific component σx

t+1. The density function and cumulative density function of


t+1 are given by fx

t (ωx

t+1) and Fx

t (ωx


We assume that each borrower receives a standard debt contract from the bank. This
specifies a nominal loan amount Lx

t(j) and a gross nominal retail rate of interest ix

r,t to be

paid if ωx

t+1 is sufficiently high to rule out default. The critical difference between our
model and those of Bernanke et al. (1999) and Christiano et al. (2011) is that the interest
rate ix

r,t is assumed to be pre-committed in period t, rather than being determined in
period t+ 1 after the realization of time t+ 1 aggregate shocks. The latter, conventional
assumption ensures zero ex-post profits for banks at all times, while under our debt
contract banks make zero expected profits, but realized ex-post profits generally differ
from zero. Borrowers who draw ωx

t+1 below a cutoff level ¯ωx

t+1 cannot pay this interest
rate and go bankrupt. They must hand over all their assets to the bank, but the bank can
only recover a fraction (1−ξx

) of the asset value of such borrowers. The remaining
fraction represents monitoring costs, which are assumed to be partially paid out to
households in a lump-sum fashion, with the remainder representing a real resource cost.
Banks’ ex-ante zero profit condition for borrower group x, in real terms, is given by



t(j)− 1−Fx


t+1) rx


t(j) + (1−ξx

) ¯ωx


0 xt(j)retx,t+1ωx


t (ωx

)dωx = 0 .

This states that the payoff to lending must equal wholesale interest charges rℓ,t+1ˇℓx


The first term in square brackets is the gross real interest income on loans to borrowers
whose idiosyncratic shock exceeds the cutoff level, ωx

t+1 ≥ ¯ωx

t+1. The second term is the

amount collected by the bank in case of the borrower’s bankruptcy, where ωx

t+1 < ¯ωx

This cash flow is based on the return retx,t+1ω on the asset xt(j), but multiplied by the
factor (1−ξx

) to reflect a proportional bankruptcy cost ξx

. The ex-post cutoff

productivity level is determined by equating, at ωx

t = ¯ωx

t, the gross interest charges due in

the event of continuing operations rx


t−1(j) to the gross idiosyncratic return on the

borrower’s asset retx,txt−1(jωx

t. Using this equation, we can replace the previous

equation by the zero-profit condition

Et rℓ,t+1ˇℓx

t − ˇxtretx,t+1 (Γx,t+1−ξx

Gx,t+1) = 0 ,



For mortgage loans, due to a lower Basel risk-weighting, the wholesale interest rate rh

ℓ,t+1 is lower than



where Γx,t+1 is the bank’s gross share in the earnings of the underlying asset

Γx,t+1 = ¯ωx


0 ωx


t (ωx


t+1 + ¯ωx





t (ωx


t+1 ,

and ξx

Gx,t+1 is the proportion of earnings of the asset that the lender has to spend on

monitoring costs


Gx,t+1 = ξx ¯ωx


0 ωx


t (ωx


t+1 .

In other words, the bank will set the terms of the lending contract, in particular the
unconditional nominal lending rate ix

r,t, such that its expected gross share in the earnings
of the underlying assets is sufficient to cover monitoring costs and the opportunity cost of
the loan. The borrower is left with a share 1−Γx,t+1 of the asset’s earnings.

The remainder of the analysis is very similar to Bernanke et al. (1999). Specifically, the
borrower selects the optimal level of investment in the respective assets by maximizing
Et{(1−Γx,t+1) ˇxtretx,t+1} subject to (5). Borrower-specific indices can in each case be
dropped because the problems are linear in balance sheet quantities. For the case of
capital investment funds, whose owners will be referred to as entrepreneurs, the condition
for the optimal loan contract is identical to Bernanke et al. (1999),


(1−Γk,t+1) retk,t+1

rℓ,t+1 + ˜λk



Γk,t+1 −ξk


−1 = 0 , (6)

with ˜λk

t+1 = Γω

k,t+1/ Γω

k,t+1 −ξk


, and where Γω

k,t+1 and

k,t+1 are the derivatives

of Γk,t+1 and Gk,t+1 with respect to ¯ωk


For the remaining three types of loan contract there are some small differences to (6).
First, the nature of the asset is different. For capital investment funds the value of the
asset equals xt = qtkt, where kt is the real capital stock and qt is the shadow value of
installed capital (Tobin’s q). For mortgages this is replaced by the value of constrained
households’ land pa


t, where ac

t is holdings of land and pa

t is the price of land. For
consumer loans and working capital loans it is replaced by the value of deposit balances dc

and dm

t . Second, for these last two cases deposit balances enter a transactions cost
technology, so that in the conditions for the optimal loan contracts of those two agents
there will be additional terms due to monetary wedges. Similarly, land enters the utility
function of constrained households, which means that the condition for the optimal
mortgage loan contract contains an additional utility-related term.

The net worth evolution of each borrower group is affected by banks’ net loan losses.
These are positive if wholesale interest expenses, which are the opportunity cost of banks’
retail lending, exceed banks’ net (of monitoring costs) share in borrowers’ gross earnings
on their assets. This will be the case if a larger than anticipated number of borrowers
defaults, so that, ex-post, banks find that they have set their pre-committed retail lending
rate at an insufficient level to compensate for lending losses. Of course, if losses are
positive for banks, this corresponds to a gain for their borrowers.

Finally, according to Fisher (1936) banks’ optimism about business conditions is a key
driver of business cycle volatility. We evaluate this claim by studying, in both the current


monetary environment and under the Chicago Plan, a standardized shock Sz

t that

multiplies each standard deviation of borrower riskiness, σx

t, x ∈ {c,a,m,k}. Similar to
Christiano et al. (2011) and Christiano et al. (2010), this shock captures the notion of a
generalized change in banks’ perception of borrower riskiness. We assume that it consists
of two components, Sz

t = Sz1

t Sz2

t . We specify the first component as consisting of the sum

of news shocks εnews

t received over the current and the preceding 12 quarters,


t = Σ12


tj , while the second component is autoregressive and given by


t = ρz lnSz2

t−1 +εz2

t .

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