Introduction

The recent global recession has prompted significant policy responses to support aggregate demand in many countries. A number of central banks have deployed a broader range of policy tools than usual, including so-called ‘unconventional’ monetary policies that involve the purchase of assets by the central bank. There are several potential approaches to unconventional monetary policy depending on, among other things, whether the assets are purchased from the government or the private sector and whether the purchases are associated with an expansion of the monetary base. In general, however, these policy actions affect the size and/or composition of the central bank’s balance sheet.

As noted by Meier (2009), different approaches to unconventional monetary policy can be motivated by alternative views of the transmission channels through which they affect activity and inflation. This chapter considers a ‘portfolio balance’ transmission mechanism, in which purchases of assets held by the private-sector increase the prices of those assets. As asset prices increase, yields fall and private-sector borrowing costs are reduced, stimulating aggregate demand. Importantly, such asset purchases may provide the policy maker with a policy instrument that can be operated even during periods where the short-term nominal interest rate typically used to implement monetary policy reaches a lower bound.