Authors: Vasco Cúrdia and Michael Woodford

We extend a standard New Keynesian model both to incorporate heterogeneity in spending opportunities along with two sources of (potentially time-varying) credit spreads and to allow a role for the central bank’s balance sheet in determining equilibrium. We use the model to investigate the implications of imperfect financial intermediation for familiar monetary policy prescriptions and to consider additional dimensions of central bank policy—variations in the size and composition of the central bank’s balance sheet as well as payment of interest on reserves—alongside the traditional question of the proper operating target for an overnight policy rate. We also study the special problems that arise when the zero lower bound for the policy rate is reached. We show that it is possible to provide criteria for the choice of policy along each of these possible dimensions within a single unified framework, and to achieve policy prescriptions that apply equally well regardless of whether financial markets work efficiently or not and regardless of whether the zero bound on nominal interest rates is reached or not.