Abstract

We study the optimal joint interest rate and central bank balance sheet policies in a macro model with financial sector, sticky prices, aggregate and idiosyncratic risk. The optimal policy mix ensures an efficient path of aggregate output, as well as efficient distributions of consumption and risk across agents. With a fixed balance sheet composition, interest rate policy alone can close the output gap and implement the efficient path of the aggregates. It can also ensure its (near) efficient distribution, but only in a small vicinity around the stochastic steady state. Distributional efficiency away from the steady state requires active balance sheet management. The role of balance sheet policy is preparatory – it ensures that the effects of future shocks are distributed efficiently across agents, given the intended interest rate responses to those shocks.