Monetary Policy Trade-Offs in a Portfolio Model with Endogenous Asset Supply

Abstract

This paper develops an open economy portfolio balance model with endogenous asset supply. Domestic producers choose an optimal capital structure and finance capital goods through credit, bonds and equity assets. Private households hold a portfolio of domestic and foreign assets, shift balances depending on risk-return considerations, and maximise real consumption in accordance with the law of one price.Within this general equilibrium model, it will be shown that central bank interventions may promote an inefficient international allocation of real capital. The application of expansive monetary interventions throughout the course of economic crises maintains the domestic stock of real capital at the cost of inflation, currency devaluation, distortions of interest rates and asset prices, and risk clusters on the central bank’s balance sheet. Exchange rate stabilising interventions have the result that the central bank can also stabilise the domestic stock of real capital. However, such interventions produce risk clusters on the central bank’s balance sheet and may cause changes in the domestic price level.