Staff Working Paper No. 1,063
By Richard Harrison
This paper studies optimal monetary policy in a New Keynesian model with portfolio frictions that create a role for the central bank balance sheet as a policy instrument. Central bank purchases of long‑term government debt (‘quantitative easing’) reduce average portfolio returns, thereby increasing aggregate demand and inflation. Optimal time‑consistent policy prescribes large and rapid asset purchases when the policy rate hits the zero bound. Optimal balance sheet reduction (‘quantitative tightening’) is more gradual. A central bank that pursues a flexible inflation target can achieve similar welfare to optimal policy if quantitative tightening is calibrated appropriately.
Optimal quantitative easing and tightening