Conventional vs Unconventional monetary policy under financial repression

Abstract

We extend a simple Dynamic Stochastic General Equilibrium (DSGE) model with segmented financial markets to include financial repression and examine its impact on the transmission of conventional and unconventional monetary policies. In our model, financial repression arises as the government forces banks to hold a fraction of their assets in government debt. We show that such distortions can invert monetary transmission under quantitative easing (QE) policy: an expansionary QE program raises term premiums on corporate bonds and causes a contraction instead of an expansion in the economy. Such perversion is absent under conventional policy. Further, in contrast to the literature Carlstrom et al. (2017), we show that a simple Taylor rule welfare dominates a term premium peg under financial shocks while the peg does better in the case of non-financial shocks.