Introduction

An almost intractable hand was dealt to central bankers in the aftermath of the financial storm of 2007–8, which culminated with the collapse of Lehman Brothers. The scale of the negative demand shock meant that central bankers found themselves bumping up against the zero lower bound for short-term policy rates, as nominal income growth went negative. A parallel debate ensued about the appropriate level of capital and liquidity for financial intermediaries, which has led to the Basel III agreement. Finally, central banks had to deal with the frozen interbank markets and burgeoning levels of bad debt and poorly performing assets. Quantitative easing is a new instrument of monetary policy, which in some degree can be thought of as finessing this triplet, and so in this note we are interested in the extent to which it can substitute for or, indeed, complement the usual instrument, which is the short-term policy rate. This problem is considered here by calibrating and simulating three recently developed DSGE models. These model constructs are used to consider how QE, or more generally balance sheet policies, might achieve their objectives.

Each of the recently developed DSGE models differs from the ‘plain vanilla’ New Keynesian case by having more than one interest rate. So as well as a New Keynesian core model with forward-looking households and firms, optimising profits and consumption streams – subject to sticky prices and central bank operations conducted with an active interest rate rule – in each model one or more interest rates impact on aggregate demand and have some traction on stabilising the economy. The creation of models with more than one interest rate means that the short-term interest rate performs as an approximate control device at all times and an especially problematic one when the zero lower bound (ZLB) acts to constrain the interest rate path.