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On the Relevance of Open Market Operations

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  • Andreas Schabert

Abstract

This paper reexamines the role of open market operations for short-run effects of monetary policy in a New Keynesian framework. The central bank supplies money in exchange for securities that are discounted with the short-run nominal interest rate, while money demand is induced by a liquidity constraint. We allow for a legal restriction by which only government bonds are eligible. Their supply is bounded by fiscal policy that is assumed to be Ricardian. If public debt is dominated in rate of return by private debt, open market operations matter, and an endogenous liquidity premium and a liquidity effect arise. Nominal interest rate setting (including a peg) is then associated with price level and equilibrium uniqueness, regardless whether prices are flexible or set in a staggered way. Thus, the legal restriction overcomes indeterminacies due to an unbounded money supply, as implied by the real bills doctrine. Moreover, it facilitates constant money growth and interest rate policy to be equivalent.

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Bibliographic Info

Paper provided by University of Cologne, Department of Economics in its series Working Paper Series in Economics with number 4.

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Date of creation: 15 Dec 2003
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Handle: RePEc:kls:series:0004

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Keywords: Legal Restriction on Eligible Securities; Liquidity and Risk-free Rate Puzzle; Price Level and Equilibrium Determinacy; Policy Equivalence; Ricardian Fiscal Policy;

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  1. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Avoiding Liquidity Traps," CEPR Discussion Papers 2948, C.E.P.R. Discussion Papers.
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  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
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  8. Sargent, Thomas J & Wallace, Neil, 1982. "The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1212-36, December.
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  21. Sargent, Thomas J & Smith, Bruce D, 1987. "Irrelevance of Open Market Operations in Some Economies with Government Currency Being Dominated in Rate of Return," American Economic Review, American Economic Association, vol. 77(1), pages 78-92, March.
  22. Smith, Bruce D, 1988. "Legal Restrictions, "Sunspots," and Peel's Bank Act: The Real Bills Doctrine versus the Quantity Theory Reconsidered," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 3-19, February.
  23. Charles T. Carlstrom & Timothy S. Fuerst, 2003. "Money Growth Rules and Price Level Determinacy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(2), pages 263-275, April.
  24. Wallace, Neil, 1981. "A Modigliani-Miller Theorem for Open-Market Operations," American Economic Review, American Economic Association, vol. 71(3), pages 267-74, June.
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