## Monetary Policy in an Equilibrium Portfolio Balance Model

_IMF Working Papers, March 1, 2007_

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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

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### 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/monetary-policy-in-an-equilibrium-portfolio-balance-model-20610_