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Optimal Quantitative Easing in a Monetary Union

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Bond market characteristics play a key role in transmitting quantitative easing (QE) in an open economy. The periphery and core countries of the euro area (EA) show large differences in these characteristics. For example, periphery countries prefer domestic long-term government bonds in their portfolios, and they rely less on short-term instruments to rebalance those portfolios following QE purchases. The periphery also has a higher ratio of government debt to gross domestic product.

We build a two-country model with portfolio rebalancing effects. This allows us to study the optimal monetary policy (interest rate adjustments and QE purchases) in a monetary union. The model is characterized by the dimensions of portfolio heterogeneity across regions. In the model, an optimal QE policy is [determined/defined] by not only the size of the region but also the characteristics of the portfolio.

We find that an optimal monetary policy that uses both interest rate adjustments and QE purchases shifts the monetary union away from the zero lower bound faster than using interest rate adjustments alone, which involves forward guidance. By calibrating our model to the EA, we find that ideally, the central bank would purchase more government bonds from the smaller, periphery region instead of the core. This is because the periphery faces stronger portfolio frictions. Finally, our model predicts that central bank purchases that reflect the European Central Bank’s practice place less-than-ideal weight on the periphery.