Asset Purchase Policy at the Effective Lower Bound for Interest Rates
55 Pages Posted: 27 Jan 2012
Date Written: January 27, 2012
Abstract
This paper studies optimal policy in a stylised New Keynesian model that is extended to incorporate imperfect substitutability between short-term and long-term bonds. This simple modification provides a channel through which asset purchases by the policymaker can affect aggregate demand. Because assets are imperfect substitutes, central bank asset purchases that alter the relative supplies of assets can influence their prices. In the model, aggregate demand depends on the prices (or interest rates) of both long-term and short-term bonds. To the extent that central bank asset purchases reduce long-term interest rates (over and above the effect of expected future short rates), aggregate demand can be stimulated, leading to higher inflation through a standard New Keynesian Phillips Curve. However, the imperfect substitutability between bonds that gives asset purchases their traction also reduces the potency of conventional monetary policy because reductions in the short-term nominal interest rate reduce the relative supply of short-term bonds, increasing the premium on long-term bonds. Nevertheless, a policy in which the policymaker uses asset purchases as an additional policy instrument can improve outcomes in the face of a negative demand shock that drives the short-term policy rate to its lower bound. This is true even if asset purchases policies are also subject to (both upper and lower) bounds.
Keywords: Monetary policy, zero bound, asset purchase policies
JEL Classification: E52, E58
Suggested Citation: Suggested Citation
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