Optimal Macro-Financial Stabilization in a New Keynesian Preferred Habitat Model

Walker Ray (LSE)

October 6, 2023, 14:00–15:15


Room Auditorium 4

Finance Seminar


We develop a general equilibrium model featuring heterogeneous households, nominal rigidities, and limits to arbitrage due to segmentation in long-term bond markets. While conventional policy alone can stabilize aggregate fluctuations, the presence of market segmentation implies that such a policy leads to excessively volatile term premia in long-term yields, imperfect risk sharing, consumption dispersion, and welfare losses. When the central bank has access to balance sheet tools, we derive a separation principle for optimal policy: conventional policy stabilizes the output gap while balance sheet policy stabilizes term premia. Only when the short rate is constrained should balance sheet policy be used for macroeconomic stabilization, but this comes at the cost of imperfect financial stabilization. Thus, optimal policy may appear, at times, to be working against itself; our model implies that in the current period of high inflation, some central banks may wish to hike policy rates more aggressively while simultaneously expanding the balance sheet.