Bernanke's No-arbitrage Argument Revisited: Can Open Market Operations in Real Assets Eliminate the Liquidity Trap?

Abstract

We first show that, at least in theory, open market operations in real assets can be a useful tool for overcoming a liquidity trap because they change the inflation incentives of the government, and thus change private sector expectations from deflationary to inflationary. We argue that this formalizes Ben Bernanke's arbitrage argument for why a central bank can always increase nominal demand, despite the zero lower bound. We illustrate this logic in a calibrated New Keynesian model assuming the government acts under discretion. Numerical experiments suggest, however, that the needed intervention is incredibly high, creating a serious limitation of this solution to the liquidity trap. Our experiments suggest that while asset purchases can be a helpful commitment device in theory, they may need to be combined in practice with fiscal policy coordination to achieve the desired outcome.

A Skeptical View of the Impact of the Fed’s Balance Sheet

“…For example, if a higher fraction of publicly held Treasury debt is of short duration, in some states of the world the Treasury might be forced to raise distortionary taxes or the Fed tolerate higher inflation in a situation where they would prefer not to be forced to do so. Hamilton and Wu (2012) and Eggertsson and Proulx (2016) proposed this as one possible mechanism whereby LSAP could end up exerting real effects, essentially as a form of Odyssean state-dependent forward guidance which could potentially influence long-term interest rates through both an expectations component and the term premium. Woodford (2012) noted that Fed purchases of Treasury securities could also have real effects by influencing a possible safety premium.…”

The Efficacy of Large-Scale Asset Purchases When the Short-Term Interest Rate Is at Its Effective Lower Bound

“…Richer models allow for the possibility of some effects. For example, buying long-term assets may commit the fiscal or monetary authority to a different statecontingent path for distortionary taxes or inflation (Hamilton and Wu 2012;Eggertsson and Proulx 2016). Or if some assets confer unique benefits on certain institutions-for example, as collateral for repurchase agreements or to satisfy capital requirements-there could also be real effects from altering the supply of these special assets (Woodford 2012;Caballero and Farhi 2017).…”

When should central banks engage in private sector securities purchases?

“…Asset bubbles, liquidity traps, "nationalisation" of lending, lower investment returns due to overinvestment, income redistribution, lower real wages (Hoffmann and Schnabl, 2016). Purchases can rarely be high enough (Eggertsson and Proulx, 2016). Administrative reasons also make such policies undesirable (Stone et al, 2011) a Note(s): a Stone and his colleagues make irrefutable claims about the macroeconomic distortions and public sector distortions such purchases would cause.…”