The recent financial crisis has led the US Federal Reserve to set the policy rate close to its zero lower bound. It further introduced several lending facilities and direct asset purchases, which eased access to reserves in a way that led to a doubling of its balance sheet after September 2008. These policies demonstrate that there are more instruments available for central banks than the pre-crisis view on monetary policy has suggested by its focus on pure interest rate policy. In contrast to the latter view, central banks usually do not accommodate money demand in an unrestricted way.
The Federal Reserve, for instance, has created a structural de?ciency, i.e. "permanent additions to the supply of reserve balances that are somewhat less than the total need", and has additionally lent money in open market operations via repurchase agreements (repos), which are essentially collateralized loans. Hence, by relaxing collateral requirements or by direct asset purchases it can ease rationing of money supply, which has been thought to be e¤ective during the recent crisis by reducing interest rate spreads and facilitating private sector credit flows (see Blinder, 2010, and Goodfriend, 2010).
This raises the questions if rationing of money can be justi?ed in terms of welfare and how it should be used in non-crisis times. Economic theory has however not considered the role of money rationing via collateralized central bank lending for the optimal conduct of monetary policy.
This paper aims to ?ll this gap. It will be shown that a central bank can enhance welfare by employing additional instruments that are neither considered in stylized textbook models (see Woodford, 2003) nor in larger models developed for estimation purposes (see Smets and Wouters, 2007, or Christiano et al., 2010).
Optimal Central Bank Lending