A Simple Model of the Operational Framework for Monetary Policy

In response to the subprime crisis in 2008, central banks lowered their short rates rapidly, but came up against the zero-interest rate floor. To ensure the liquidity of the financial system, they then decided a Quantitative Easing policy of buying securities massively, mainly government bonds. Their balance sheets began to swell, reaching historically unprecedented levels of 8960 billion USD for the Fed, 8500 billion euros for the ECB. Then, in 2022, when the world was confronted with an inflation that took central bankers by surprise, they embarked on a rise in short rates that was unprecedented in its speed and force. Inflation has receded, and while the markets are only thinking of lower rates, central bankers are wondering what to do with the large stocks of securities they are holding. In today's jargon, how do you reconcile lower rates with a necessary quantitative tightening? And, if we look to the future and broaden our perspective, what use should be made of the two instruments now available to central banks: interest rates and quantitative monetary policy? How can we get away from the current sequential vision: first, act on rates (downwards in 2008, upwards in 2022), then, in a second phase, implement a quantitative policy (upwards in 2009, downwards in 2024)? In this paper, we attempt to provide an answer to this very legitimate question. We develop a simple, general equilibrium model, which can be solved analytically, to understand and analyze monetary policy from an "operational" point of view. The aim is not so much to describe the macroeconomic ecects of monetary policy as to study what is often referred to as the "plumbing" or "piping" that a central bank must consider when implementing the decisions it takes to stabilize the economy or ensure financial stability. This operational vision is even more important given that, on several occasions, central banks, and the Fed in particular, have come up against obstacles that have cast doubt on their ability to return to the previous situation, or even to a significant reduction in their balance sheet. Once the model presented and solved analytically, we ask ourselves what the optimal policy for the Central Bank, the one that, in a way, should replace the Taylor rule, should be? The main result is that we should not be concerned so much with whether the reduction of Central banks balance sheets is feasible, as with whether it is desirable. Our results point in the opposite direction to the general view: it may be preferable to increase the amounts outstanding held by the Central banks rather than reduce them. The first part presents the model. It is then solved analytically, and the question of optimal Central bank policy is posed (section 2). This leads to the result announced above. A simulation (section 3), using a calibration based on eurozone data, confirms the model's results and gives plausible orders of magnitude.