Central Bank Balance Sheet Concerns, Monetary and Fiscal Rules, and Macroeconomic Stability∗

We provide a fully articulated theoretical foundation for the view that a central bank’s (CB) balance sheet concerns may hinder monetary policy “activism” needed to achieve macroeconomic stability. When the Taylor rule is constrained by the zero lower bound on the nominal interest rate, there emerges a second steady state equilibrium which has the properties of a liquidity trap. CB’s balance sheet concerns makes it more likely for an economy to drift towards the liquidity trap equilibrium even under the Taylor Principle. In a reserve-based monetary system based on net worth targeting and central bank independence, monetary activism embodied in the Taylor Principle cannot be applied to its full extent, monetary conservatism may lead to local indeterminacy and bifurcation and embeds in the economic system an inherent tendency towards structural instability. This can only be averted by an institutional reform ensuring better monetary-fiscal cooperation. Our results have important implications on the institutional design for the European System of Central Banks, the Bank of Japan, and existing pseudo-currency-board regimes in Hong Kong and Singapore.