Asymmetric Shocks in a Currency Union: The Role of Central Bank Collateral Policy

Abstract

Currency unions limit the ability of the central bank to use interest rate policy to accommodate asymmetric shocks. I show that collateral policy can serve to dampen asymmetric shocks in a currency area when these shocks also affect the collateral held by banks and when collateral portfolios of banks differ systematically across countries. In my model banks from 2 countries use collateral to borrow from the money market or a central bank that targets a level of interest rate (or investment) in each economy. The distressed bank may enter a “collateral crunch” regime where it is constrained in its access to funding due to a moral hazard problem. The central bank faces an heterogeneous transmission of its interest rate: a unit change in rate has a smaller effect on the economy rate of the distressed country. The central bank therefore sets a high interest rate which is well transmitted in the booming economy and relaxes the haircut on the collateral owned by the distressed bank.