Gertler and Karadi, ”A Model of Unconventional Monetary Policy”

Akio Ino

April 14, 2010

1. Introduction 2
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Overview of the model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2. The Baseline Model 5

2.1 Households . . . . . . . . . . . . . . . . . . ..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2 Financial Intermediaries . . . . . . . . . ..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3 Credit Policy . . . . . . . . . . . . . . . . . ..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.4 Intermediate Goods Firms . . . . . . . . ..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.5 Capital Producing Firms . . . . . . . . . ..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.6 Retail Firms . . . . . . . . . . . . . . . . . ..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.7 Resource Constraint and Government Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

3. Model analysis 19
3.1 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2 Experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.3 Optimal Policy and welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

1
1. Introduction 2 / 23

Introduction
■ This paper incorporate the financial intermediary which faces the balance sheet problem in a
DSGE model.

■ The model is used to investigate

1. the effect of monetary policy shocks under imperfect financial intermediation, and
2. the effect of ”unconventional monetary policy”.

■ This paper also consider the case where the zero lower bound of interest rate is binding.

■ Optimal Monetary Policy is explored.

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Overview of the model

Retail Goods

Household

Retailer 1

.
.
.
Government Bond Deposit Retailer 2

Finan ial Intermediary .

Government .
.

Short term bond Short term bond

Intermediate Goods Firm

Intermediate Goods

Capital

Capital Produ ing Firm

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2
2. The Baseline Model 5 / 23

2.1 Households
■ Each Household consists of a continuum of agents, with the fraction 1 − f of workers and f of
bankers.

■ Bankers quit the financial intermediary with probability θ in each period.

■ The Households problem is

∞
∑ [ ]
χ
maxEt β i
ln(Ct+i − hCt+i−1 ) − L1+φ (1)
1 + φ t+i
t=0
s.t. Ct = Wt Lt + Πt + Tt + Rt Bt − Bt+1 (2)

■ A Household obtains wage Wt Lt , lump-sum tax Tt , dividends Πt and returns from short term
debt Rt Bt and uses them to buy consumption goods Ct and short term debt Bt+1 .

■ The cashless Economy Assumption as in Woodford (2003).

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2.1 Households
■ The FONC for the households problem is

ρt Wt = χLφ
t (3)
Et βΛt,t+1 Rt+1 = 1 (4)
−1 −1
where ρt = (Ct − hCt−1 ) − βhEt (Ct+1 − hCt )
ρt+1
Λt,t+1 =
ρt

■ Hereafter, βΛt,t+1 is used as the stochastic discount factor for firms.

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2.2 Financial Intermediaries
■ Financial intermediary j with net worth Njt borrows Bjt from Households to purchase Sjt units
of financial claims on non-financial firms at Qt :

Qt Sjt = Njt + Bjt (5)

■ The deposits pays the gross return Rt+1 , while that of financial clam is Rk,t+1 .

■ The net worth of FI j evolves according to:

Nj,t+1 = Rk,t+1 Qt Sjt − Rt+1 Bt (6)

= (Rk,t+1 − Rt+1 )Qt St + Rt+1 Njt (7)

■ FI can transfer the asset to the household to which the banker belongs, but if this happens, the
fraction 1 − λ of asset is used to repay the deposits.

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2.2 Financial Intermediaries

■ The FI maximizes its expected terminal wealth subject to the balance sheet constraint:

[∞ ]
∑
Vjt = max Et (1 − θ)θi β i Λt,t+i Nj,t+1+i (8)
i=0
s.t. Vjt ≥ λQt Sjt (9)

■ Vjt can be expressed as follow:

Vjt =νt Qt Sjt + ηt Njt , where (10)

[ ]
Qt+1 Sj,t+1
νt =Et (1 − θ)βΛt,t+1 (Rk,t+1 − Rt+1 ) + βΛt,t+1 θ νt+1
Qt Sjt
[ ] (11)
Nj,t+1
ηt =Et (1 − θ)βΛt,t+1 Rt+1 + βΛt,t+1 θ ηt+1
Njt

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2.2 Financial Intermediaries
■ Now the incentive constraint can be written as

νt Qt Sjt + ηt Njt ≥ λQt Sjt (12)

■ If the constraint is binding in equilibrium, the demand for assets is determined by the net worth:
ηt
Qt Sjt = Njt ≡ ϕt Njt (13)
λ − νt

■ The evolution of the FI’s net worth is given by

Nj,t+1 = [(Rk,t+1 − Rt+1 )ϕt + Rt+1 ]Njt (14)

■ Since ϕt does not depend on j, we can sum up (13) to obtain

Qt Spt = ϕt Nt (15)

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2.2 Financial Intermediaries

■ Nt can be divided into two parts: existing bank’s net worth (Net ) and new bank’s net worth
(Nnt )

Nt = Net + Nnt (16)

■ Net is given by

Net = θ[(Rkt − Rt )ϕt + Rt ]Nt−1 (17)

■ Assume the household give new banker the fraction ξ/(1 − θ) of existing bank’s asset value:

Nnt = ξQt St−1 (18)

■ (17) and (18) imply the law of motion for Nt :

Nt = θ[(Rkt − Rt )ϕt + Rt ]Nt−1 + ξQt St−1

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2.3 Credit Policy
■ Government can lend to the non-financial firm at interest rate Rk,t+1 by raising funds from
households at Rt+1 :

Qt St = Qt Spt + Qt Sgt (19)

■ Suppose the amount of lending by government is

Qt Sgt = ψt Qt St (20)

■ Under this credit policy, the aggregate demand for claims is

Qt St =ϕt Nt + ψt Qt St
1
∴ Q t St = ϕt Nt ≡ ϕct Nt
1 − ψt

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2.4 Intermediate Goods Firms

■ Intermediate Goods Firms use capital Kt and labor input Lt to produce intermediate goods Yt .

■ At the end of period t Int firms buy capital Kt+1 for use in production in next period.

■ After production, firms have option to sell the capital.

■ Firms issue claims St to finance the expenditure on capital Kt+1 :

Qt Kt+1 = Qt St (21)

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2.4 Intermediate Goods Firms
■ Since a firm’s desicion is made at the end of the period t, the maximization problem is

max Et βλt,t+1 [Pm,t+1 Yt+1 + (Qt+1 − δ(Ut ))ξt+1 Kt+1 − Rt+1 Qt Kt+1 − Wt+1 Lt+1 ] (22)

■ After production, capital depreciate at the rate of δ(Ut ), where Ut represents the utilization rate.

■ Depreciated capital can be repaired with a unit of intermediate goods.

■ ξt+1 denotes the quality of capital.

■ The intermediate firm’s FONC is

[ Yt+1 ]
Pm,t+1 α Kt+1
+ (Qt+1 − δ(Ut ))ξt+1
Et βΛt,t+1 Rt+1 =Et βλt,t+1 (23)
Qt
Yt+1
δ ′ (Ut+1 ) =Pm,t+1 α (24)
Ut+1
Yt+1
Wt+1 =Pm,t+1 (1 − α) (25)
Lt+1

■ These equations says marginal cost (LHS) is equal to marginal benefit (RHS).

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2.5 Capital Producing Firms

■ Capital producing firms buy capital from Int. firms, repair that capital, and build new capital on
it.

■ The maximization problem for a capital producing firms is

[∞ { ( ) }]
∑ I nτ + I ss
maxEt β τ Λt,τ (Qτ − 1)Inτ − f (Inτ + Iss )
τ =t
I n,τ −1 + Iss (26)
with Int ≡ It − δ(Ut )ξt Kt

■ The FONC gives Q relation:

( )2
Int + Iss ′ In,t+1 + Iss
Qt = 1 + f (·) + f (·) − βEt Λt,t+1 f ′ (·) (27)
In,t−1 + Iss In,t + Iss

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2.6 Retail Firms
■ Differentiated retail firms use the imtermediate goods to produce inputs for final goods.

■ The final output composite is given by

[∫ 1 ε−1
] ε−1
ε

ε
Yt = Yf t df (28)
0

where Yf t represents the output from a retail firm f , f ∈ [0, 1].

■ Cost minimization of households implies the following demand function:

( )
Pf t −ε
Yf t = Yt (29)
Pt
[∫ 1 1
]1−ε
Pt = Pf1−ε
t df (30)
0

■ As in Christiano, Eichenbaum and Evans (2005), retail firms face (1) Calvo pricing (2) partial
indexation, and (3) demand function .

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2.6 Retail Firms

■ The maximization problem for a retail firm f is given by
[∞ { } ]
∑ Pf
∗ ∏
t
i
max Et γ i β i Λt,t+i (1 + πt+k−1 )γp − Pm,t+i Yf,t+i
Pf∗t Pt+i
i=0 k=0 (31)
( )−ε
Pf t
s.t. Yf t = Yt
Pt

■ The FONC is
∞
[ ]
∑ Pf∗t ∏
i
i i
γ β Λt,t+1 (1 + πt+k−1 ) γp
− µPm,t+1 Yf,t+i = 0 (32)
Pt+i
i=0 k=0

where 1 − γ represents the probability of price adjustment and µ = 1/(1 − 1/ε).

■ The price level evolves according to

1 1
Pt = [(1 − γ)(Pt∗ ) 1−ε + γ(πt−1
γ
p
Pt−1 ) 1−ε ]1−ε (33)

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 2.7 Resource Constraint and Government Policy
■ Since there is a intermediation cost in government intermediation, the resource constraint is
( )
Int + Iss
Yt = Ct + It + f (Int + Iss ) + G + τ ψt Qt Kt+1 (34)
In,t−1 + Iss

■ Government purchase is financed by lump-sum tax and government intermediation:

G + τ ψt Qt Kt+1 = Tt + (Rkt − Rt )Bg,t−1 (35)

■ Monetary Policy follows a Taylor rule with interest rate smoothing:

it = (1 − ρ)[ī + ιπ πt + ιy (log Yt∗ − log Yt )] + ρit−1 + εt (36)

and the linkage between nominal and real interest rate is given by the fisher equation:
Pt+1
1 + it = Rt+1 (37)
Pt

■ Credit policy ψt follows the feedback rule

ψt = ψ + ν[(Rk,t+1 − Rt+1 ) − (Rk − R)] (38)

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3. Model analysis 19 / 23

3.1 Calibration
■ Table 1 lists the choice of Parameters.

■ For conventional parameters, this paper uses the estimates of CEE and Primiceri-Tambalotti
(2009).

■ Three financial parameters (λ, ξ, θ) is set so that the model can replicate

1. a steady state interest rate spread of one hundred basis point,

2. a steady state leverage ratio of four, and
3. average horizon of bankers of a decade.

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3.2 Experiments
■ Investigate the effect of three structural shocks : productivity shock, interest rate shock, and
intermediary’s net worth shock.

■ Each shock is amplified by the balance sheet constraint on financial intermediaries.

■ A decline in productivity → Investment decreases → Asset price decreases → Net worth

decreases → Risk premium increases → demand for capital decreases · · ·

■ An increase in interest rate → bank’s cost of borrowing increases → lending decreases → output
decreases · · ·

■ Redistribution of net worth: from financial intermediaries to households → the amount of

lending decreases → output decreases · · ·

■ In these cases, the inability of banker to finance causes the amplification of the shocks.

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3.2 Experiments: Credit Policy

■ What happens if there is an unanticipated decline in the quality of capital?

■ This exeriment intends to the financial crisis caused by the decline in the quality of asset held by
the financial intermediaries.

■ Without Credit Policy, the effect of capital quality shock is very large .(Figure 2)

■ With Credit Policy, and the increase in ν reduces the depth of the recession. (Figure 3)

■ Zero lower bound on interest rate leads to the severe recession. (Figure 4)

■ The gain from credit policy increases if there is zero lower bound. (Figure 5)

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3.3 Optimal Policy and welfare
■ The objective of policy maker is to maximize households’ utility.

■ Using the second order approximation of the model and numerical optimization, find ν that
maximizes households’ lifetime utility.

■ The welfare gain in each efficiency cost τ and the relationship between efficiency cost τ and ν is
obtained. (Figure 6)

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