Abstract
We show that the path of inflation under quantitative easing policies that target interest rates, is determinate in the presence of default. We achieve this through different payoff profiles that a collateralised defaultable bond achieves in different states of nature with distinct default outcomes. In the model, heterogeneous households trade this bond and other shorter maturity risk-free bonds to maximize their intertemporal utility of consumption and labour. The differentiated payoffs of the collateralised bond, in an equilibrium with active default, span the full state space giving determinacy of prices and inflation as an outcome. This, implies that quantitative easing as implemented by the ECB in the recent years, can control the stochastic path of inflation.
Highlights
The interconnection between the real and monetary parts of the economy creates the question of how price levels and inflation are being determined in equilibrium
We show that the path of inflation under quantitative easing policies that target interest rates, is determinate in the presence of default
This paper presented a model that features trade in fiat money, one physical good, one real asset, riskeless short term loans and collateralized risky long term loans
Summary
The interconnection between the real and monetary parts of the economy creates the question of how price levels and inflation are being determined in equilibrium. The main goal of this paper is to establish, using a variant of the Lin et al (2016) model, that the introduction of default in the setting of McMahon et al (2018), resolves the indeterminacy of the price level and the inflation path under QE. We hasten to add that this result obtains whenever there is default in all future states of nature and the central bank sets the collateral requirements exogenously This implies that the QE that was implemented by the ECB in the recent years can be efficient in achieving the economic outcomes it seeks, part of which consists of determining the inflation path. The quantity theory of money obtains and the central bank determines the price level and inflation path by targeting the interest rates of both the short term and long term loans.
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