The Central-Bank Balance Sheet as an Instrument of Monetary Policy ∗

While many analyses of monetary policy consider only the adjustment of a central bank’s target for a short-term nominal interest rate, other dimensions of policy have recently been of greater importance: changes in the supply of bank reserves beyond those required to achieve an interest-rate target, changes in the assets acquired by central banks, and changes in the interest rate paid on reserves. We extend a standard New Keynesian model to allow a role for the central bank’s balance sheet in equilibrium determination, and consider the connections between these alternative dimensions of policy and traditional interest-rate policy. We distinguish between “quantitative easing” in the strict sense and targeted asset purchases by a central bank, and argue that while the former is likely be ineffective at all times, the latter dimension of policy can be effective when financial markets are sufficiently disrupted. Neither is a perfect substitute for conventional interest-rate policy, but purchases of illiquid assets are particularly likely to improve welfare when the zero lower bound on the policy rate is reached. We also consider optimal policy with regard to the payment of interest on reserves, and argue that the interest rate on reserves should be kept near the central bank’s target for the policy rate at all times. ∗Prepared for the 75th Carnegie-Rochester Conference on Public Policy, “The Future of Central Banking,” April 16-17, 2010. We thank Gauti Eggertsson, Marvin Goodfriend, James McAndrews, Kazuo Ueda and Tsutomu Watanabe for helpful discussions, and the NSF for research support of the second author. The views expressed in this paper are those of the authors and do not necessarily reflect positions of the Federal Reserve Bank of New York or the Federal Reserve System. The recent global financial crisis has confronted central banks with a number of questions beyond the scope of standard accounts of the theory of monetary policy. Monetary policy is ordinarily considered solely in terms of the choice of an operating target for a short-term nominal interest rate, such as the federal funds rate in the case of the Federal Reserve. Yet during the recent crisis, other dimensions of policy have occupied much of the attention of central bankers. One is the question of the appropriate size of the central bank’s balance sheet. In fact, the Fed’s balance sheet has grown dramatically in size since the fall of 2008 (Figures 1 and 2). As shown in Figure 1, the component of the Fed’s liabilities constituted by reserves held by depository institutions has changed in an especially remarkable way: by the fall of 2008 reserves were more than 100 times larger than they had been only a few months earlier. This explosive growth has led some commentators to suggest that the main instrument of US monetary policy has changed, from an interest-rate policy to one often described as “quantitative easing. ” Does it make sense to regard the supply of bank reserves (or perhaps the monetary base) as an alternative or superior operating target for monetary policy? Does this (as some would argue) become the only important monetary policy decision once the overnight rate (the federal funds rate) has reached the zero lower bound, as it effectively has in the US since December 2008? And now that the Federal Reserve has legal authorization to pay interest on reserves (under the Emergency Economic Stabilization Act of 2008), how should this additional potential dimension of policy be used? The past two years have also seen dramatic developments with regard to the composition of the asset side of the Fed’s balance sheet (Figure 2). Whereas the Fed had largely held Treasury securities on its balance sheet prior to the fall of 2007, other kinds of assets — a variety of new “liquidity facilities”, new programs under which the Fed essentially became a direct lender to certain sectors of the economy, and finally targeted purchases of certain kinds of assets, including more than a trillion dollars’ worth of mortgage-backed securities — have rapidly grown in importance, and decisions about the management of these programs have occupied much of the attention of policymakers during the recent period. How should one think about the aims of these programs, and the relation of this new component of Fed policy to traditional interest-rate policy? Is Federal Reserve credit policy a substitute