Economics Webinar - Optimal Macro-Financial Stabilization in a New Keynesian Preferred Habitat Model

We develop a general equilibrium model featuring heterogeneous households, nominal rigidities, and limits to arbitrage due to segmentation in long-term bond markets. Even when conventional monetary policy can stabilize aggregate fluctuations, the presence of market segmentation implies excessively volatile term premia in long-term yields, imperfect risk sharing, and consumption and labor dispersion. The effectiveness of conventional policy alone is limited; to improve welfare, the central bank must reduce the volatility of short-rate fluc­tuations, but this implies a degree of macro- economic volatility. However, when the central bank has access to balance sheet tools, we derive a separation prin­ciple for optimal policy: conventional policy stabilizes the output gap while unconventional policy stabilizes risk premia. Only when the short rate is con­strained should balance sheet policy be used for macroeconomic stabilization, but this comes at the cost of imperfect financial stabilization.