The macroprudential role of central bank balance sheets

Summary

Focus

Is there a role for central bank balance sheets away from the effective lower bound on interest rates? Should central banks maintain lean balance sheets, and how do these relate to those of financial intermediaries?

Contribution

This paper extends the canonical macro-finance dynamic stochastic general equilibrium model to derive optimal monetary and balance sheet policies when the central bank faces a tight budget constraint. Specifically, it examines how the central bank can influence the short- and long-run composition of the balance sheets of financial intermediaries by financing asset purchases mainly through the issuance of reserve deposits to banks.

Findings

Even outside the lower bound of policy rates, adjusting the size and composition of its balance sheet allows the central bank to impact the economy's response to shocks. This serves as an additional policy tool alongside conventional interest rate policy. However, the effectiveness of this additional tool depends on the strategy of conventional monetary policy. When conventional policy is conducted optimally, little additional benefit may emerge from balance sheet policies. Yet, a crucial factor influencing the effectiveness of conventional policy is the size and composition of the central bank's long-run balance sheet. By calibrating the model to the observed maturity structure of public debt and evidence on convenience yields of debt and reserves, we find that a large balance sheet could enhance the effectiveness of conventional policy in managing the business cycle.

Abstract

Is there a role for central bank balance sheet policies away from the effective lower bound on interest rates? We extend the canonical DSGE model with financial frictions to include a fully specified central bank balance sheet. We find that the balance sheet size and composition can play a macroprudential role in improving the efficacy of monetary policy. The optimal balance-sheet policy aims at affecting duration risk held by banks in order to increase their resilience to shocks. Optimal short-run balance sheet policies bring no additional advantage to using the policy rate alone provided the optimal long-run balance sheet is already in place. Our results also highlight a key role for government debt maturity and bank regulation in determining optimal central bank balance sheets. 

JEL classification: E42, E44, E51, E52, G2

Keywords: optimal monetary policy, central bank balance sheet, government debt, reserves, financial frictions, macroprudential