Working Paper: CEPR ID: DP7514
Authors: Vasco Curdia; Michael Woodford
Abstract: 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.
Keywords: credit frictions; credit spread; interest on reserves; quantitative easing
JEL Codes: E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Variations in the size and composition of the central bank's balance sheet (E58) | Effectiveness of monetary policy (E52) |
| Higher credit spreads (G19) | Inhibit spending and investment (E62) |
| Central bank's ability to influence credit spreads through balance sheet management (E51) | Enhance economic stability (E63) |
| Traditional focus on interest rate policy alone (E52) | Inadequate in the face of financial disruptions (F65) |
| Monetary policy actions (E52) | Market responses (D49) |