Unwinding Quantitative Easing

In order to tackle the crisis of 2007-2008, central banks around the globe brought interest rates to historically low levels and bought unprecedented volumes of government debt, mortgage-backed securities, agency debt and commercial paper. These asset purchases fostered the creation of large excess reserves held by financial intermediaries at central banks. Now that the crisis is over, it’s time to tighten monetary policy so as to avoid overheated economies and excessive inflation. However, higher interest rates may induce commercial banks to lend their excess reserves which may accelerate the economy even further – this is what monetary tightening is supposed to prevent in the first place. In this paper, I modify a DSGE model to see whether there is any risk that current interest rate hikes may induce spikes in the inflation rate. Simulating the model using Dynare platform in MATLAB showed that despite the existence of large excess reserves on banks’ balance sheets, inflation rate and aggregate output go below their steady state level after a shock of increasing nominal interest rates, proving the above seemingly plausible reasoning wrong.