A Model of Credit, Money, Interest and Prices

Project Outcomes Statement

Since the onset of the Great Financial Crisis of 2008, the major central banks around the world began conducting large purchases of assets and injecting significant amounts of money into their economies. However, central bankers acted instinctively, doing so without the guide of a proper theoretical model that could be useful to make predictions and evaluate such policies.

The paper "A Model of Credit, Money, Interest and Prices" by Saki Bigio and Yuliy Sannikov presents a macroeconomic framework focused on examining the optimal management of a central bank's balance sheet precisely designed to fill that gap. The authors address the question of what the appropriate size of the Federal Reserve's balance sheet is and how it interacts with more conventional tools, such as the interest the Federal Reserve pays on its reserves, particularly in relation to the business cycle.

The authors wrote a model that considers imperfect financial markets and incorporates unemployment and rigid prices. The model suggests that the Federal Reserve can effectively respond to macroeconomic shocks by maintaining a relatively small balance sheet during economic booms and expanding it during recessions. This approach comes with a trade-off: such policies raise borrowing rates and make individual unemployment spells more painful. This cost is counterbalanced by the achieved macroeconomic stability that limits the extent of unemployment during financial crises.