Alternative Central Bank Credit Policies for Liquidity Provision in a Model of Payments

Abstract

I explore alternative central bank credit policies in a theoretical model where (i) money is necessary as a means of payment, (ii) there is a shortage of liquidity that a central bank addresses through the extension of credit, (iii) money is necessary to repay debts, and (iv) the incentives to default are explicit and contingent on the credit policy designed. Using a mechanism design approach, I compare a credit policy of charging an interest rate on credit (like the Federal Reserve's policy) with that of requiring the posting of collateral (like the European Central Bank's policy). I find that the pricing policy can implement good allocations while the collateral policy cannot whenever collateral bears an opportunity cost