The interaction between the central bank and government in tail risk scenarios

This paper presents an original approach of the strategic interaction between governments and the central bank with regard to unconventional monetary policy. Crisis measures to remove tail risk are analysed with an adjusted Merton model in a game theoretical set-up. It shows that the participation constraint for interventions by the central bank and the governments is less binding if the risk of contagion is high. The strategic interaction between governments and the central bank also influences the effectiveness of the interventions. A joint effort of both the governments and central bank leads to a better outcome. To prevent a bad equilibrium, a sizable commitment by both players is required. The outcomes help to understand the dynamics behind the Outright Monetary Transactions (OMTs) of the Eurosystem.
 
Keywords: Financial crisis, Monetary policy, Central banks, Policy coordination.
JEL Classification: E42, E52, E61, G01, G18.

Working paper no. 352