Monetary Policy with Inelastic Asset Markets

I develop a New Keynesian model to study the transmission of both conventional and unconventional monetary policy through financial markets. The model’s two key features are (i) heterogeneous financial intermediaries with downward-sloping asset demand curves, and (ii) households that face frictions in reallocating their savings across intermediaries. The central bank directly controls the risk-free rate, whereas the risk premium is determined by the distribution of intermediaries’ wealth and the central bank’s purchases of risky assets. Interest rate hikes reduce long-term risky asset values, redistributing wealth away from risk-tolerant intermediaries and increasing the risk premium. Central bank asset purchases can initially stimulate investment by reducing the risk premium, but asset prices may undershoot when those purchases are unwound. Optimal policy simultaneously uses both interest rate cuts and asset purchases to stabilize asset prices during downturns.