Default Risk and Unconventional Monetary Policies

  • Cheol Soo ParkEmail author


The purpose of this study is to clarify the mechanism of financial friction in a simple two-period model, which is a two-period version of the Gertler-Kiyotaki model, in an attempt to enhance understanding of financial instability. Our focus is on financial firms’ balance sheet channel of transmission of adverse shocks when an incentive constraint is present in financial intermediary firms and/or production firms. In this paper we show that the larger positive premium equilibrium reflects the extent of inefficiency in a financial market through the structure of incentive constraint and the size of net worth. Further we argue that the existence of a positive premium in our model depends on the relation between two factors in states space: the degree of pledgeability or lack of a commitment of financial firm/bank toward investors, as well as the state of net worth of the financial intermediary.

As policy implications, unconventional monetary policy in our model means the various measures to shift the premium curve inward as close as possible. Thus this study suggests that monetary policy in a broad sense should consider not only prudence of net worth but also mechanism design to affect the incentive structure of financial firms/intermediaries. In this sense, the effect of a particular intervention depends crucially on how an incentive compatibility constraint is designed and enforced.

Key words

Financial friction Balance sheet Monetary policy Pledgeability Incentive structure 

JEL ClassificationCode

E50 E60 E61 E65 


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An earlier version of this paper has been presented at the JEPA International Conference of Japan Economic Policy Association in 2012. I thank Prof. Toru Nagahara, Prof. Masumi Kishi and anonymous referees for valuable comments, and I also acknowledge the presenters and coordinators of workshop 2012 at Tsinghua University for allowing me to share ideas regarding financial issues and research agenda when initiating this paper as a preliminary part of the MECSST project. This research project was supported by JSPS Kakenhi from MECSS: the Ministry of Education, Culture, Sports, Science and Technology (Grant No.23530353).


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Copyright information

© Japan Economic Policy Association (JEPA) 2013

Authors and Affiliations

  1. 1.Graduate School of EconomicsKumamoto Gakuen UniversityChuo-ku, Kumamoto CityJapan

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