Time Consistency and the Duration of Government Debt: A Signalling Theory of Quantitative Easing

Abstract

We present a signalling theory of Quantitative Easing (QE) at the zero lower bound on the short term nominal interest rate. QE is effective because it generates a credible signal of low future real interest rates in a time consistent equilibrium. We show these results in two models. One has coordinated monetary and fiscal policy. The other an independent central bank with balance sheet concerns. Numerical experiments show that the signalling effect can be substantial in both models.

An Analysis of the Literature on International Unconventional Monetary Policy

“…Moreover, calibrated DSGE models also support the hypothesis that LSAP policies lessened the negative impact on output and inflation of a binding ZLB. This research shows that both the portfolio and signaling channel can in principle be effective in DSGE models (Chen, Curdia, and Ferrero (2012) and Bhattarai, Eggertsson, and Gafarov (2015)). "Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month.…”

“…Bhattarai, Eggertsson, and Gafarov (2015) calibrate their DSGE model that features a central bank with balance sheet concerns that conducts policy under discretion, and thus a role for the signaling channel, to estimate the effects of LSAPS. In particular, they assess the effects of changing the size of the Fed's balance sheet and its duration mismatch and can therefore model both QE2 and MEP.…”

“…Then, LSAPs act as a commitment device to make the public believe that central banks will not raise interest rates too soon. Bhattarai, Eggertsson, and Gafarov (2015) present a model, without financial frictions, where LSAPs have macroeconomic effects because they affect the public's expectations of the future path of the shortterm interest rate. Although the government/central bank in the model cannot fully credibly promise a future path of the policy (instrument), it can change the size and/or composition of the central bank balance sheet to affect both long-term yields and macroeconomic quantities through a signaling channel.…”

Quantitative Easing in Joseph's Egypt with Keynesian Producers

“…Here, JQE potentially improves economic outcomes by shrinking the set of feasible paths that are consistent with equilibrium. Previous models of liquidity traps featuring policy-relevant QE have either featured frictions that impede private borrowing and lending (Cúrdia and Woodford, 2011;Gertler and Karadi, 2011), financial markets segmented by asset maturity (Chen, Cúrdia, and Ferrero, 2012), or limited commitment that can be overcome somewhat by manipulating the maturity structure of the monetary authority's balance sheet (Bhattari, Eggertsson, and Gafarov, 2014). In all of those approaches, QE can potentially improve a given equlibrium outcome.…”

Gradualism and Liquidity Traps

“…Eggertsson (2006) and Burgert and Schmidt (2014) show that in models with non-Ricardian fiscal policy and nominal government debt, discretionary policymakers can incentivize future policymakers to keep policy rates low for long by means of expansionary fiscal policy that raises the nominal level of government debt. Jeanne and Svensson (2007), Berriel and Mendes (2015), and Bhattarai, Eggertsson, and Gafarov (2015) find that central banks' balance-sheet policies can, under certain conditions, operate as a commitment device for discretionary policymakers that facilitates the use of low-for-longer policies. Finally, Billi (2015) explores policy delegation schemes where the discretionary central bank's inflation-targeting objective is replaced by either a price-level or a nominal-income stabilization objective.…”