Optimal Unconventional Policy in a New Keynesian Preferred Habitat Model

Rupal Kamdar and Walker Ray

No 22023, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We study conventional and balance sheet policy in a general equilibrium model with heterogeneous households, nominal rigidities, and limits to arbitrage. Both instruments move risk prices through portfolio rebalancing; because household portfolios differ in duration, the induced term premium fluctuations lower welfare through imperfect risk-sharing. Conservative calibrations imply these welfare costs are comparable to or larger than those of traditional stabilization motives. When divine coincidence holds and both instruments are unconstrained, optimal policy satisfies a separation principle: conventional policy stabilizes output and inflation, while balance sheet policy stabilizes term premia. If the short rate is constrained, balance sheet policy is a necessary but imperfect tool for macroeconomic stabilization; with costly balance sheet tools, a less reactive short rate improves welfare at the cost of greater macroeconomic volatility. Under commitment, the path of the short rate can mitigate households' exposure to aggregate risk. Our results justify a central bank "triple mandate" that includes term premia alongside output and inflation, and challenge the view that balance sheet policy is a close substitute for the short rate.

JEL-codes: D14 E43 E44 E52 (search for similar items in EconPapers)
Date: 2026-10
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