a european history lesson for todays central bankers.pdfVIP

A European History Lesson for Today’s Central Bankers∗ Hanno Lustig UCLA and NBER Treasury bonds provide money-like services, while other bonds do not. These money-like services, which include safety and liquidity, are valued more during financial crises, reduc- ing the substitutability of actual Treasuries and synthetic Treasuries—other types of bonds that yield the same cash flows. Large equilibrium yield spreads between actual and syn- thetic Treasuries result. During the recent U.S. financial crisis, large-scale asset purchases by the Federal Reserve may have widened these spreads. To avoid policy-induced instability in bond markets, monetary authorities may have to stand ready to exchange actual and synthetic Treasuries at fixed exchange rates. These recent episodes of instability in the bond mar- kets are analogous to the occasional large depreciations of small coins experienced by economies that used commodity money during periods of perceived shortages of small coins. This source of monetary instability was eventually eliminated by fixing the exchange rate of different coins (Sargent and Velde 2002). JEL Codes: E43, E44. 1. Introduction In the era of commodity money, many economies struggled with occasional, large depreciations of small coins. Sargent and Velde (2002) trace these episodes back to a failure on the part of author- ities to fully understand the value that money derives from its role ∗This commentary was prepared for the IJCB 4th Financial Stability Confer- ence held at the Hong Kong Monetary Authority, for the session on “The Impact of Unconventional