Conventional and Unconventional Monetary Policy

We extend a standard New Keynesian model to incorporate heterogeneity in spending opportunities and two sources of (potentially time-varying) credit spreads, and to allow a role for the central bank’s balance sheet in equilibrium determination. We use the model to investigate the implications of imperfect financial intermediation for familiar monetary policy prescriptions, and to consider additional dimensions of central-bank policy — variations in the size and composition of the central bank’s balance sheet, and payment of interest on reserves — alongside the traditional question of the proper choice of an operating target for an overnight policy rate. We also give particular attention to the special problems that arise when the zero lower bound for the policy rate is reached. We show that it is possible to provide criteria for the choice of policy along each of these possible dimensions, within a single unified framework, and to provide policy prescriptions that apply equally when financial markets work efficiently and when they are subject to substantial disruptions, and equally when the zero bound is reached and when it is not a concern. ∗Prepared for the conference “Debt, Financial Markets, and Monetary Policy,” Federal Reserve Bank of St. Louis, October 15-16, 2009. We thank Michele Boldrin, Gauti Eggertsson, Marvin Goodfriend, Jamie McAndrews, John Taylor and Kazuo Ueda for helpful discussions, Neil Mehrotra, Ging Cee Ng and Luminita Stevens for research assistance, 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 many conventional accounts of the theory of monetary policy. For example, do projections of the paths of inflation and of aggregate real activity under some contemplated path for policy provide a sufficient basis for monetary policy decisions, or must financial conditions be given independent weight in such deliberations? (The fact that the Fed began aggressively cutting its target for the federal funds rate, in late 2007 and early 2008, while inflation was arguably increasing and real GDP was not yet known to be contracting — and has nonetheless often been criticized as responding too slowly in this period — suggests that familiar prescriptions that focus on inflation and real GDP alone, such as the Taylor (1993) rule or common accounts of “flexible inflation targeting” (Svensson, 1997), may be inadequate to circumstances of the kind recently faced. As a further, more specific question, how should a central bank’s interest rate policy be affected by the observation that other key interest rates no longer co-move with the policy rate (the federal funds rate, in the case of the US) in the way that they typically have in the past? (The dramatically different behavior of the LIBOR-OIS spread, shown in Figure 1, since August 2007, has drawn particular comment. Indeed, John Taylor himself (Taylor, 2008) has suggested that movements in this spread should be taken into account in an extension of his famous rule. ) In addition to such new questions about traditional interest-rate policy, the very focus on interest-rate policy as the central question about monetary policy has been called into question. The explosive growth of base money in the US since September 2008 (shown in Figure 2) has led many 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? See Mishkin (2008) for discussion of some of the considerations behind the Fed’s relatively aggressive rate cuts in the early part of the crisis.