Are Direct Investments by the Federal Reserve a Good Idea? A Corporate Finance Perspective

March 10, 2016

Due to the crisis of 2007–2009, financial friction macro models are being used to provide a theoretical foundation for the evaluation of ‘unconventional policy’. In these models, banks take deposits from households and lend to firms. Empirically, other financial channels that are missing in the models, such as corporate bonds and equity, are also important. This paper analyzes a model in which bank loans and equity are both feasible. Households have limited ability to enforce their claims. If either the bank or the equity market are undistorted, the equilibrium is socially efficient. If both are distorted, the equilibrium is inefficient. In that case, government policy aimed at the bank or at the firm can be helpful. Suitably chosen equity injections, loans, or interest rate subsidies can all work. Interest rate subsidies have the advantage that they occur later and there is less concern about cheating. Equity injections have the advantage that they minimize the necessary level of tax imposed on households that is needed to achieve optimality. Optimal equity injections and optimal loan subsidies induce reductions in household savings (‘crowding out’). Optimal interest rate subsidies induce increases in household savings (‘crowding in’).