Forward Guidance and Financial Stability in a Model of Optimal Central Bank Swap Lines

Abstract

The main goal of this study is to develop a dynamic equilibrium model of central bank swap lines that helps understand the recent observed behaviors of foreign reserves and to analyze the potential effect of the Federal Reserves foreign exchange swap lines on the determination of international reserves and exchange rates. The model focuses on the issue of moral hazard that can arise with the liquidity provision of the Federal Reserve through its swap lines with other central banks. This study argues that a standard debt contract under asymmetric information between lenders and borrowers may not work to model actual swap lines between the Federal Reserve and foreign central banks because lenders tend to accept credit risks in debt contract models. This study shows that debt contracts between the Federal Reserve and foreign central banks are inferior to swap contracts in the presence of the informational advantage of foreign central banks for local financial institutions in their jurisdictions. Although the proposed model is primarily intended to understand the contractual relation between the Federal Reserve and foreign central banks, it can also serve as a determination model for the nominal exchange rate. A policy implication of this model is that short-run and longrun channels are available through which the expectation formation of agents is affected by the behavior of international reserves and the credible long-term stance of the monetary policy.