Keywords: Payments systems, central banking, liquidity, collateral
Abstract: I explore alternative central bank policies for liquidity provision in a model of payments. I use a mechanism
design approach so that agents' incentives to default are explicit and contingent on the credit policy designed.
In the first policy, the central bank invests in costly enforcement and charges an interest rate to recover costs.
I show that the second best solution is not distortionary. In the second policy, the central bank requires
collateral. If collateral does not bear an opportunity cost, then the solution is first best. Otherwise,
the second best is distortionary because collateral serves as a binding credit constraint.
Full paper (209 KB PDF)
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Last update: January 4, 2006