Revisiting the New Keynesian policy paradoxes under QE

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 19 February 2021

Staff Working Paper No. 908

By Dario Bonciani and Joonseok Oh

Standard New Keynesian models deliver puzzling results at the effective lower bound of short-term interest rates: greater price flexibility amplifies the fall in output in response to adverse demand shocks; labour tax cuts are contractionary; the multipliers of wasteful government spending are large. These outcomes stem from a failure to characterise monetary policy correctly. Both analytically and numerically, we show that allowing the central bank to respond to inflation with quantitative easing (QE) can resolve all these paradoxes. In quantitative terms, mild adjustments to the central bank’s balance sheet are sufficient to obtain results more in line with conventional wisdom.

Revisiting the New Keynesian policy paradoxes under QE

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