Monetary Policy in an Equilibrium Portfolio Balance Model
IMF Working Papers, March 1, 2007
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- Monetary Policy in an Equilibrium Portfolio Balance Model
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Bibliographic details
- Authors: Michael Kumhof, Stijn van Nieuwerburgh
- Published: March 1, 2007
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451866360.001
Summary findings
- Standard theory: sterilized foreign exchange interventions do not affect equilibrium prices and quantities; domestic and foreign currency denominated bonds are perfect substitutes.
- Key result of the paper: when fiscal policy is not sufficiently flexible in response to spending shocks, perfect substitutability breaks down and uncovered interest rate parity no longer holds.
- Government balance sheet operations can be used as an independent policy instrument to target interest rates.
- Sterilized foreign exchange interventions should be most effective in developing countries, where fiscal volatility is large and where the fraction of domestic currency denominated government liabilities is small.
Mechanism and model implications
- Breakdown condition: insufficient fiscal flexibility in response to spending shocks leads to loss of perfect substitutability between domestic and foreign currency denominated bonds.
- Consequence: uncovered interest rate parity no longer holds, allowing domestic policy actions on government liabilities to influence interest rates.
- Policy instrument role: government balance sheet operations become an independent tool for interest-rate targeting under the model’s conditions.
Policy recommendations and applicability
- Use government balance sheet operations as a monetary policy tool when fiscal rigidity prevents bond substitutability.
- Implement sterilized foreign exchange interventions particularly in developing countries characterized by:
- large fiscal volatility, and
- a small fraction of government liabilities denominated in domestic currency.