Working Paper: NBER ID: w26067
Authors: Eric R. Sims; Jing Cynthia Wu
Abstract: This paper develops a New Keynesian model featuring financial intermediation, short and long term bonds, credit shocks, and scope for unconventional monetary policy. The log-linearized model reduces to four key equations – a Phillips curve, an IS equation, and policy rules for the short term nominal interest rate and the central bank's long bond portfolio (QE). The four equation model collapses to the standard three equation New Keynesian model under a simple parameter restriction. Credit shocks and QE appear in both the IS and Phillips curves. Optimal monetary policy entails adjusting the short term interest rate to offset natural rate shocks, but using QE to offset credit market disruptions. The ability of the central bank to engage in QE significantly mitigates the costs of a binding zero lower bound.
Keywords: New Keynesian model; quantitative easing; credit shocks; monetary policy
JEL Codes: E1; E50; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal monetary policy involves adjusting the short-term interest rate (E52) | output gap (E23) |
| credit shocks (G21) | output gap (E23) |
| credit shocks (G21) | IS curve (D11) |
| credit shocks (G21) | Phillips curve (E31) |
| quantitative easing (QE) (C54) | output gap (E23) |
| quantitative easing (QE) (C54) | inflation (E31) |
| central bank's ability to engage in QE (E58) | costs associated with binding ZLB (H60) |
| QE serves as a substitute for conventional policy actions (C54) | output gap (E23) |
| QE serves as a substitute for conventional policy actions (C54) | inflation (E31) |