Research Seminar - Huixin Bi (Kansas City Federal Reserve Bank) - Asset Purchases in a Monetary Union with Default and Liquidity Risks

Co-authors: Andrew Foerster (FRB San Francisco) and Nora Traum (HEC Montréal)

Using a two-country monetary-union framework with sovereign default and liquidity risks, we quantify the efficacy of asset purchases in stabilizing the financial and economic sectors.  Financial intermediaries supply credit to the public and private sectors, and sovereign default follows from an endogenous regime-switching process.  The default probability additionally affects the overall tightness of the credit market, giving rise to liquidity risks.  While the presence of both risks dampen economic and financial conditions following an increase in government debt, the magnifying effect from liquidity risks is far more consequential, making asset purchases markedly more effective when liquidity risks are present.

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