Designing QE in a fiscally sound monetary union

This paper develops a tractable two-country model of a monetary union with a sound fiscal governance structure and a portfolio balance channel and shows how in such environment the design of QE can be linked to well-understood findings applying to single economies. If the monetary union is symmetric and there is no portfolio balance channel, our linearised model converges to the canonical New Keynesian economy, in which central bank purchases of long-term debt (QE) are ineffective at the zero lower bound constraint for the short-term interest rate. However, if the portfolio balance channel is present, monetary policy in the form of both negative short-term interest rates (up to a certain endogenous lower bound) and QE becomes effective. We prove that for shocks of certain size there exists an interest rate rule, augmented by QE, which substitutes for negative short-term rates prescribed by a conventional interest rate rule without QE. We generalise this result to an asymmetric monetary union, allowing for asymmetric shocks and asymmetric structures. As long as asymmetries between countries result from shocks, outcomes under negative short-term rates can be replicated with a rule augmented by a symmetric design of QE. By contrast, asymmetric structures affecting the transmission of monetary policy can translate into an asymmetric QE design. In general, lower bound episodes in asymmetric monetary unions give rise to current account imbalances which are, depending on the degree of financial integration, funded by private capital imports or absorbed through the central bank balance sheet channel.