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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page Alternative Central Bank Credit Policies for Liquidity Provision in a Model of Payments
David C. Mills, Jr.

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.

Keywords: Payments systems, central banking, liquidity, collateral

Full paper (209 KB PDF)

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Last update: January 4, 2006