A Model of Post-2008 Monetary Policy

Abstract

Since the end of 2008, the Federal Reserve has been communicating its monetary policy in terms of two instruments under its direct control: the interest rate on bank reserves (IOR rate), and the size of its balance sheet. We introduce banks and bank reserves into the basic New Keynesian model to assess the main consequences of this policy change. We show that our model can account, in qualitative terms, for three key features of US inflation during the 2008-2015 zero-lower-bound (ZLB) episode: no significant deflation, little inflation volatility, and no signficant inflation following quantitative-easing policies. Crucial to this result is our assumption that demand for bank reserves got close to satiation, but did not reach full satiation. We introduce liquid government bonds into the model to reconcile our non-satiation assumption with the fact that Treasury-bill rates dropped below the IOR rate during the ZLB episode. Looking ahead, we explore the implications of our model for the normalization of monetary policy and its future operational framework (floor vs. corridor system). In particular, we find that current and expected future IOR-rate hikes and balance-sheet contractions are always deflationary in our model, thus ruling out Neo-Fisherian effects.