Optimal Macro-Financial Stabilization in a New Keynesian Preferred Habitat Model
Dr. Walker Ray
Economist
Economic Research Department
Federal Reserve Bank of Chicago
We develop a general equilibrium model featuring heterogeneous households, nominal rigidities, and limits to arbitrage due to segmentation in long-term bond markets. Even when conventional monetary policy can stabilize aggregate fluctuations, the presence of market segmentation implies excessively volatile term premia in long-term yields, imperfect risk sharing, and consumption and labor dispersion. The effectiveness of conventional policy alone is limited; to improve welfare, the central bank must reduce the volatility of short-rate fluctuations, but this implies a degree of macroeconomic volatility. However, 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 unconventional policy stabilizes risk 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.
