Modeling Monetary Policy
We develop a macroeconomic framework where money is supplied against only few eligible securities in open market operations. The relationship between the policy rate, expected inflation and consumption growth is affected by money market conditions, i.e. the varying liquidity value of eligible assets and the associated risk. This induces a liquidity premium, which explains the observed systematic wedge between the policy rate and consumption Euler interest rate that standard models equate. It further implies a dampened response of consumption to policy rate shocks that is humpshaped when we account for realistic central bank transfers and the dynamics of bond holdings.
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