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Monetary Policy with Inelastic Asset Markets

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Abstract

I develop a New Keynesian model to study the transmission of both conventional and unconventional monetary policy through financial markets. The model’s two key features are (i) heterogeneous financial intermediaries with downward-sloping asset demand curves, and (ii) households that face frictions in reallocating their savings across intermediaries. The central bank directly controls the risk-free rate, whereas the risk premium is determined by the distribution of intermediaries’ wealth and the central bank’s purchases of risky assets. Interest rate hikes reduce long-term risky asset values, redistributing wealth away from risk-tolerant intermediaries and increasing the risk premium. Central bank asset purchases can initially stimulate investment by reducing the risk premium, but asset prices may undershoot when those purchases are unwound. Optimal policy simultaneously uses both interest rate cuts and asset purchases to stabilize asset prices during downturns

Suggested Citation

  • Joseph Abadi, 2025. "Monetary Policy with Inelastic Asset Markets," Working Papers 25-15, Federal Reserve Bank of Philadelphia.
    • Handle: RePEc:fip:fedpwp:99901
    DOI: 10.21799/frbp.wp.2025.15
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    References listed on IDEAS

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    1. Itamar Drechsler & Alexi Savov & Philipp Schnabl, 2018. "A Model of Monetary Policy and Risk Premia," Journal of Finance, American Finance Association, vol. 73(1), pages 317-373, February.
    2. Arvind Krishnamurthy & Annette Vissing-Jorgensen, 2011. "The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 42(2 (Fall)), pages 215-287.
    3. Borio, Claudio & Zhu, Haibin, 2012. "Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?," Journal of Financial Stability, Elsevier, vol. 8(4), pages 236-251.
    4. Yili Chien & Harold Cole & Hanno Lustig, 2011. "A Multiplier Approach to Understanding the Macro Implications of Household Finance," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 78(1), pages 199-234.
    5. Arvind Krishnamurthy & Annette Vissing-Jorgensen, 2011. "The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 43(2 (Fall)), pages 215-287.
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    Keywords

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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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