BANK BALANCE SHEETS, COLLATERAL CONSTRAINTS, AND OPTIMAL FISCAL AND MONETARY POLICY

Abstract

This thesis studies the revaluation effect of inflation on bank balance sheets and its implications for fiscal and monetary policy.

Chapter 1 offers an empirical assessment of the gains and losses caused by unanticipated higher inflation to the U.S. commercial banks through their exposure to fixed-income instruments. Due to the mismatch of maturity between assets and liabilities, a persistent increase in the inflation rate causes a larger decline in banks' asset value than in liability value. We quantify this effect using the regulatory reports filed by the U.S. commercial banks. Our key finding is that a persistent increase in the inflation rate causes sizable losses to U.S. commercial banks.

Chapter 2 studies the implications of bank balance-sheet costs of inflation for the design of fiscal and monetary policy in response to fiscal shocks. We augment standard models with collateral constraints to account for this cost of inflation. In our model, banks hold nominal government debts, and inflation reduces the real value of government debts and tightens banks' collateral constraints. We study the Ramsey optimal fiscal and monetary policy in this model. Compared to the prescription of perfect tax smoothing in standard models, our model features a much smaller role for inflation in buffering higher government spending. We also extend the model to incorporate price stickiness and long-term government debts. We find that the maturity of government debts crucially impacts the size and persistence of the inflation process in the optimal policy.

Chapter 3 introduces nominal loans into the framework to capture the empirical fact that the majority of banks' fixed-income assets are long-term nominal loans to the business and household sectors. In this model, inflation affects bank balance sheets mainly through loan portfolios, as in the data. In the calibrated model, We find that the bank balance-sheet costs of inflation discourage the use of inflation in the optimal policy. Particularly, the assumption that loans are nominal is important for the quantitative results. In a sticky-price setting, we find that the maturities of firm loans and government debts significantly impact the role of inflation in the optimal policy.