Bail out the money printer? The impact of fiscal indemnity on central bank profitability

Dianyi Yang

No wz75m, SocArXiv from Center for Open Science

Abstract: Since 2022, central bank losses have been prevalent in advanced economies due to previous quantitative easing and recent inflationary pressures. This paper focuses on the unique case of the United Kingdom, where the government promised in advance to cover any central bank losses arising from quantitative easing. This promise is known as the indemnity. A game-theoretical model is proposed to explain the causes and effects of such indemnity. The model's predictions about the indemnity's effect on central bank profitability are empirically examined. Using the novel Dynamic Multilevel Latent Factor Model (DM-LFM), the indemnity is found to have significantly boosted the Bank of England's profits in the deflationary environment after 2008, but exacerbated its losses under the recent inflationary pressure since 2022. The theoretical model suggests the pronounced effects are due to the Bank of England's high sensitivity to losses and the UK government's moderate fiscal liberalism. Therefore, the British experience should not be generalised. Nevertheless, the theoretical and empirical lessons can inform policy-makers about future institutional designs concerning the fiscal-monetary interactions and the public finance-price stability trade-off.

Date: 2024-08-20
New Economics Papers: this item is included in nep-cba, nep-gth and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:osf:socarx:wz75m

DOI: 10.31219/osf.io/wz75m

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