Forward Guidance and Financial Stability in a Model of Optimal Central Bank Swap Lines

Abstract

The main goal of this study is to develop a dynamic equilibrium model of central bank swap lines that helps understand the recent observed behaviors of foreign reserves and to analyze the potential effect of the Federal Reserves' foreign exchange swap lines on the determination of international reserves and exchange rates. The model focuses on the issue of moral hazard that can arise with the liquidity provision of the Federal Reserve through its swap lines with other central banks. This study argues that a standard debt contract under asymmetric information between lenders and borrowers may not work to model actual swap lines between the Federal Reserve and foreign central banks because lenders tend to accept credit risks in debt contract models. This study shows that debt contracts between the Federal Reserve and foreign central banks are inferior to swap contracts in the presence of the informational advantage of foreign central banks for local financial institutions in their jurisdictions. Although the proposed model is primarily intended to understand the contractual relation between the Federal Reserve and foreign central banks, it can also serve as a determination model for the nominal exchange rate. A policy implication of this model is that short-run and long-run channels are available through which the expectation formation of agents is affected by the behavior of international reserves and the credible long-term stance of the monetary policy.Keywords: International Reserves, Exchange Rate, Central Bank Liquidity Swap LinesJEL Classification: E31, F31, F32(ProQuest: ... denotes formulae omitted.)I. IntroductionThe recent two decades have witnessed a relatively long trend of reserve accumulation prior to the global financial crisis and its substantial declines during the crisis in the group of emerging-market countries. Before the crisis, the academia and practical policy makers remarked that that their hoarding of international reserves might be excessive in light of the so-called Guidotti-Greenspan prescription for reserve adequacy. This situation held especially for reserve stocks that were more than enough to cover potential disruptions in the international settlements of imports and even in the roll-over of their short-term external debts. During the crisis, the Federal Reserve provided foreign exchange swap lines with other central banks that include the European Central Bank, the Swiss National Bank, the Bank of Japan, and the Bank of Korea.The main goal of this study is to develop a dynamic model that helps understand the observed behaviors of foreign reserves summarized above and to analyze the potential effect of the foreign exchange swap lines of the Federal Reserves on the determination of international reserves and exchange rates. In the proposed model, foreign central banks engage in the financial intermediation between the Federal Reserve and non-U.S. financial institutions. Specifically, foreign central banks distribute U.S. dollars to local financial institutions with variable rate auctions while making currency swap contracts with the Federal Reserve.A notable feature of the foreign exchange swap lines from the Federal Reserve is that different lending rates are set for different central banks, whereas the Federal Reserve does not accept credit risks that may arise from lending to local financial institutions. Given this actual working of foreign exchange swap lines, assuming that the Fed delegates its lending capacity to foreign central banks to save intermediation costs that may arise with the asymmetric information about balance sheet conditions of local financial institutions that benefited from foreign exchange swap lines may not be unreasonable. In fact, the moral hazard that can arise with the liquidity provision of the Federal Reserve through its swap lines has been considered in the academia and practical policy circles. However, a standard debt contract under asymmetric information between lenders and borrowers may not work to model actual swap lines between the Federal Reserve and foreign central banks because lenders tend to accept credit risks in debt contract models. …