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TITLE: Macroeconomic effects of an open-ended Asset Purchase Programme1

RUNNING TITLE: Macroeconomic effects of an open-ended APP

Authors:Lorenzo Burlon (European Central Bank, Directorate General Monetary Policy)

Alessandro Notarpietro (Banca d’Italia, Directorate General for Economics, Statistics and Research)

Massimiliano Pisani(corresponding author, Banca d’Italia, Directorate General for Economics, Statistics and Research, via Nazionale 91, 00184, Rome, Italy, [email protected])

Abstract We evaluate the effectiveness of an open-ended Asset Purchase Programme (APP) using a New Keynesian model of euro area. We assume that the central bank does not announce the ending date of the programme, and agents form their expectations about possible additional purchases beyond the horizon of the announcement according to the central bank reaction function, that links the purchases to the expected inflation gap. It is showed that the open-ended APP is more effective in stimulating macroeconomic conditions than committing ex ante to an ending date.

JEL classification: E43; E44; E52; E58.

Keywords: central bank communication, open-ended announcement, non-standard monetary policy, DSGE models, open-economy macroeconomics, euro area.

1 We thank Fabio Busetti, Martina Cecioni, Sandra Gomes, Stefano Neri, and participants at the Working Group on Econometric Modeling of the European System of Central Banks (March 2018) for useful comments. All errors are ours. The opinions expressed in this paper are those of the authors and do not necessarily reflect the views of Banca d’Italia, European Central Bank, or Eurosystem.

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“We have proven in the past that our forward guidance is credible. This has

been the case both for our guidance on rates and on our reaction function,

notably when we laid out the contingencies that would justify launching an

asset purchase programme in response to a too-prolonged period of low

inflation.”

President of the European Central Bank, Mario Draghi2

1 IntroductionIn January 2015 the Eurosystem extended its asset purchase programme (APP) to euro-

denominated investment-grade securities issued by euro-area (EA) governments and

institutions in the secondary market. The reason for this decision was the progressive

fall of inflation that was leading to a de-anchoring of inflation expectations from levels

consistent with price stability and risks of a deflationary spiral. The implementation of

these measures contributed to improve EA macroeconomic conditions and favored a

substantial progress towards a sustained adjustment in the path of inflation.

In December 2016 the ECB started a recalibration of the non-standard monetary policy

measures, and in particular the APP.3

The design of this recalibration involved several decisions about its timing, size, and

composition. A feature of the recalibration was the choice between a programme with

an end date for the net purchases that is announced and a programme that remains open-

ended. The ECB chose to maintain the possibility of extending the flow of future net

2 Draghi (2018).3 See Draghi and Constancio (2017).

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purchases beyond the horizon of the purchases to which it made explicit commitment. A

careful communication was used, based on the concept of “central bank reaction

function”, aimed at managing agents’ (households’ and firms’) expectations about future

purchases of sovereign bonds, linking them to expected future macroeconomic

conditions.

In this paper we evaluate the macroeconomic effectiveness of the announcement of an

open-ended APP. To this purpose, we build a large-scale New Keynesian dynamic

general equilibrium model calibrated to the EA and the rest of the world (RW). The EA

is formalized as a monetary union of two regions, Home and rest of the EA (REA),

where Home is of medium size (its GDP being around 20% of overall EA GDP).

We assume that an open-ended programme implies no explicit commitment by the

central bank to end the purchases. Agents form their expectations about future, not yet

announced, asset purchases that the central bank would implement in the quarters past

the announced horizon according to a reaction function of the central bank. The latter

links the expected purchases to the expected inflation gap, i.e., the distance of expected

inflation from the target. If the expected inflation gap is positive, i.e., if expected

inflation is below the target, then agents expect additional purchases (that have not been

announced) and no purchases otherwise. The central bank reaction function is known by

agents on the basis of the inference that they may have drawn from previous purchases

announcements.4 We provide an empirical foundation of the reaction function by

estimating the elasticity of expected purchases to the expected inflation gap using data

4 In several speeches the ECB President Mario Draghi had suggested that the communication would have been aimed at clarifying the ECB reaction function. See, for example, Draghi (2014, 2018). According to Praet (2018b), “the convergence of market expectations towards the ECB's indications about the size and horizon of net asset purchases has proceeded in tandem with the gradual rise of in inflation expectations towards our medium-term policy aim. Likewise, there is a strong co-movement between markets views of the convergence of in inflation towards the ECBs aim on the one hand and, on the other, the length of the interval between the end of net asset purchases and the first rate rise fully priced into market rates. This suggests that our monetary policy reaction function is well understood.”

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on announced additional purchases and the inflation gap in correspondence of the

considered announcement. The estimated elasticity is positive and significant, in line

with anecdotal evidence provided by financial analysts.5 This allows us to discipline the

results of our simulations from a quantitative point of view.

We use the ECB October 2017 announcement on the pace and amount of future

purchases as a case study for our analysis. The APP consists of purchases of long-term

sovereign bonds by the EA central bank. Following Chen, Curdia, and Ferrero (2012),

we assume that in each EA country some households (labeled “restricted”) invest in

domestic long-term sovereign bonds and physical capital (they do not invest in short-

term bonds). This feature captures the presence of investors who have a demand over

specific asset classes and maturities, as formalized in the preferred-habitat framework.

The presence of these agents allows us to obtain real effects from central bank purchases

of long-term sovereign bonds, as those households’ decisions depend only on long-term

rates.6 The rest of the households (labeled “unrestricted”) have instead access to

multiple asset markets and, in particular, their decisions are directly affected by the

short-term monetary policy rates. Moreover, we assume forward guidance (FG) on the

short-term policy rate, i.e., the central bank announces the number of periods the policy

rate should be expected to remain at its current (baseline of the model) level.

The other model features are in line with those of existing large-scale dynamic general

equilibrium models of the EA, like the Eurosystem’s EAGLE (Gomes, Jacquinot, &

Pisani, 2010) and the ECB’s New Area Wide Model (Christoffel, Coenen, & Warne,

2008). In particular, we distinguish between final (non-tradable) consumption and

5 See Praet (2018b) and Skolimowski (2017).6 See Andres, Lopez-Salido, and Nelson, (2004) and Modigliani and Sutch (1966). Recently, Altavilla, Carboni, and Motto (2015), Blattner and Joyce (2016), and Ferdinandusse, Freier, and Ristiniemi (2017) have provided empirical evidence on the presence of preferred-habitat investors in the EA.

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investment goods and between intermediate tradable and non-tradable goods, produced

according to sector-specific technologies exploiting domestic capital and labor. We also

include standard nominal (price and wage) and real (consumption habit and investment

adjustment costs) frictions.

We consider several scenarios. We compare purchases under a “full” announcement

(i.e., an announcement of a purchasing programme that specifies both the overall path of

future purchases and their end date) to the case of an “open-ended” announcement, in

which the end date is not specified and the possibility of additional future purchases is

communicated. All announcements are accompanied by the FG on the short-term policy

rate. In its announcements, the ECB connected the end of the FG to the end of the APP

by explicitly communicating that monetary policy rates should be expected to remain at

their present (low) levels for an extended period of time, and, crucially, past the horizon

of net asset purchases. This assumption on the FG is consistent with the current wording

of ECB official communication, according to which the first rate hike would occur only

“well past the horizon” of net asset purchases (Draghi & Constancio, 2017).

Moreover, we assess the effectiveness of the two alternative programmes when a

negative demand shock to EA aggregate demand reduces EA in inflation and, thus,

widens the gap from the inflation target.

Our results are the following. First, the announcement of an open-ended APP is more

effective in stimulating macroeconomic conditions than an announcement that commits

to an end date. Given the initial positive inflation gap, agents expect additional

purchases in the case of open-ended APP. Thus, the long-term interest rate decreases

more than in the case of announcing an end date and economic activity and inflation

increase more. Second, the effectiveness of the open-ended programme is reinforced by

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the FG. In particular, for a given amount of announced purchases, keeping the monetary

policy rate unchanged past the purchases’ horizon stimulates economic activity and

reduces the expected inflation gap. This induces households to expect a lower amount of

additional (unannounced) purchases. Third, the open-ended APP is more effective in

stabilizing the economy if negative EA aggregate demand shocks unexpectedly

materialize and push down inflation. In this case, the widening of the inflation gap

associated with the shocks induces agents to expect a larger amount of additional

purchases by the central bank.

Among the recent studies that analyze the effectiveness of the APP, there is a growing

consensus that the adoption of the APP has had both financial and real effects, and that

the latter are mostly consistent with a portfolio rebalancing channel.7

Different from previous studies, our exercise features two EA-specific characteristics,

i.e., the monetary union and open-economy dimensions, and attempts a first description

of expectations’ formation by private agents in presence of an open-ended programme.

In Ellison and Tischbirek (2014) asset purchases are carried out according to a

systematic rule. As in that contribution, we endogenize purchases as a function of the

inflation gap, using a reaction function. Different from it, we assume that the central

bank does not systematically follow a reaction function (the reaction function is not a

systematic rule), but follows it only for a limited number of periods after the

announcement of the open ended-programme.

Burlon et al. (2017) study the macroeconomic effectiveness of an APP with announced

end-date under different assumptions regarding the duration of the purchases and of the

FG on the policy rates. One of the main conclusions of that paper is that the more distant

7 See, among others, Breckenfelder et al. (2016).

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in the future the announced closing date of a programme, the larger the (current and

future) effectiveness of the programme itself. The model used in our analysis builds on

the one in Burlon et al. (2017) with one crucial departure, i.e., the presence of the central

bank reaction function in the case of an open-ended programme. Households know the

function and use it to form their expectations about future unannounced asset purchases

by the central bank.

Our analysis clarifies that two elements of central bank communication are crucial (from

both a theoretical and a policy perspective) for the effectiveness of non-standard

measures: (1) agents’ expectations about future unannounced purchases and (2) the

ability of the central bank to shape those expectations through (past and current)

announcements. We are the first, to the best of our knowledge, to make this type of

analysis in a fully-fledged New Keynesian model.8

Thus, from a policy perspective, our paper emphasizes the key role of central bank

communication for the effectiveness of non-standard monetary policy measures.

Communication allows the central bank to manage expectations of economic agents.

This is particularly relevant when macroeconomic conditions and the monetary policy

tools are not the standard ones and, thus, are not well known by economic agents and/or

their functioning and interaction is difficult to explain to the public.9

The paper is organized as follows. Section 2 describes the main features of the model, in

particular the non-standard monetary policy measures (sovereign bond purchases by the

central bank) and the formation of agents’ expectations on future purchases by the 8 For other analyses of non-standard monetary policy measures, that, however, do not consider the central bank reaction function, see Breckenfelder et al. (20116), Darracq Paries and Kuhl (2016), Harrison (2012), Reis (2017), and Woodford (2016). See Coenen et al. (2017) for a discussion of the role of communication of monetary policy in unconventional times.9 According to Praet (2017), “In normal times, the central bank reaction function mainly specifies the contingencies for loosening, tightening or maintaining a given policy stance. In unconventional times, it also needs to spell out which tool would provide the first margin of adjustment if a change in policy stance were to appear warranted, and how the adjustment in one policy instrument would interact with the others.”

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central bank in the case of open-ended APP. Section 3 describes the simulated scenarios.

Section 4 reports the main results. Section 5 concludes.

2 The modelWe first provide an overview of the model. Subsequently, we describe its key features,

i.e., the reaction function and the EA central bank, (restricted and unrestricted)

households and capital goods producers, the fiscal authority, and the definition of

general equilibrium. Finally, we report the calibration.

2.1 Overview

The model is New Keynesian and represents a world economy composed of three

regions, i.e., Home, REA (Home+REA=EA), and RW. The size of the world economy

is normalized to 1. Home, REA, and RW have sizes equal to n, n*, and (1-n-n*), with 0

< n, n*< 1 and n+n* < 1.10 Home and REA share the currency and the central bank. The

latter sets the policy rate according to EA-wide variables (a standard Taylor rule holds)

and deliberately enacts non-standard monetary policy measures. The presence of the

RW outside the EA allows us to assess the role of the nominal exchange rate and extra-

EA trade for the transmission of the EA shocks.

Crucial features of the model are two: the central bank reaction function, used by

households to form expectations about future (unannounced) APP purchases in the

open-ended scenario, and financial market segmentation.

10 For each region, size refers to the overall population, to the number of firms operating in each sector and, in the case of each EA region, the number of capital producers.

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The first key, and novel, feature is that, under an open-ended programme, when the

central bank does not commit to an end date and keeps the possibility of continuing

purchases past the announcement horizon, agents follow a rule to form their

expectations about future unannounced purchases. The rule is the central bank reaction

function, which is known by the agents, and links the expected purchases to the

expected inflation gap, i.e., the distance of expected inflation from the target.

The second crucial feature of the model is financial market segmentation as in Chen,

Curdia, and Ferrero (2012), which allows us to relax the well-known “Wallace

neutrality” and make financial assets imperfect substitute so that sovereign bonds’

purchases by the central bank have real effects in our model.11 In each EA region there

are two types of households, “restricted” and “unrestricted.” Restricted households can

invest only in the domestic long-term sovereign bond market and domestic private

physical capital. The increase in the purchases of long-term government bonds by the

monetary authority reduces long-term interest rates (their term premium component)

and therefore induces restricted households to increase consumption and investment in

physical capital. To the opposite, unrestricted households (1) have access to the

domestic short-term private bond and long-term sovereign bond markets, (2) trade a

riskless private bond with RW households, and (3) invest in physical capital. The

consumption/saving decisions of the unrestricted households depend not only on long-

term interest rates, but also on short-term ones. Thus, FG directly affects the optimal

choices of those households, in particular consumption and investment in physical

capital through the capital producers. Finally, there are capital producers that

accumulate private physical capital by demanding final investment goods subject to

11 See Wallace (1981).

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quadratic adjustment costs on investment change. They rent out capital to the domestic

firms producing intermediate goods. They maximize profits with respect to capital and

investment taking prices as given, and evaluate returns according to a weighted average

of restricted and unrestricted households’ stochastic discount factors (where the weights

reflect the corresponding population shares). The (net) revenues are rebated in a lump-

sum way to domestic restricted and unrestricted households according to their

corresponding shares.

Remaining features of the model are standard. Households consume a final non-tradable

good which is a composite of intermediate non-tradable and tradable goods. The latter

are domestically produced or imported. All households supply differentiated labor

services to domestic firms and act as wage setters in monopolistically competitive labor

markets by charging a mark-up over their marginal rate of substitution between

consumption and leisure.

On the production side, there are perfectly competitive firms that produce two final

goods (consumption and investment goods) and monopolistic firms that produce

intermediate goods (firms are owned by domestic unrestricted households). The two

final goods are sold domestically and are produced combining all available

intermediate goods using a constant-elasticity-of-substitution (CES) production

function. The resulting bundles can have different compositions. Intermediate tradable

and non-tradable goods are produced combining domestic capital and labor. The two

factors are assumed to be mobile across sectors. Intermediate tradable goods can be

sold domestically and abroad. Since intermediate goods are differentiated, firms have

market power and, thus, are price setters and restrict output to create excess profits. We

also assume that markets for tradable goods are segmented, so that firms can set a

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different price for each of the three markets. Adjustment costs ensure that main

variables react smoothly to a shock. Specifically, on the real side, habits and quadratic

costs prolong the adjustment of consumption and investment, respectively. On the

nominal side, quadratic costs make wages and prices sticky.12 Home and REA setups

are similar, so in what follows we report only Home key equations. The RW setup is

standard (the representative household framework holds).

2.2 Expectations about future bond purchases in the open-ended APP

Consistent with the evidence on the inference by market participants reported by

Skolimowski (2017), in the “open-ended” scenarios we assume that agents (households

and firms) in both EA regions form their expectations about future central bank

purchases according to the central bank’s reaction function. The function dictates that

in correspondence of positive expected inflation gaps in the quarters past the end of

announced purchases, agents form their expectations about additional unannounced

future central bank purchases in those quarters, according to the size of the (positive)

inflation gap. Thus, we assume that in both EA regions expectations over future

unannounced purchases evolve as follows:

Et [ BAPP , t+ hL −B APP ,t+h−1

L ]=ϕAPP (π target−Et [ π t+h ] ) ,(1)

where Et is the expectation operator in quarter t, BAPP ,t+hL are purchases in quarter t+h,

π target is the constant (annualized) inflation target of the central bank, Et [ π t+h ] is the

expected (annualized) inflation rate in quarter t + h with h = 1, 2, 3, . . . , and ϕ APP>0is

12 See Rotemberg (1982).

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a parameter regulating the amount of additional future expected net central bank

purchases corresponding to each percentage-point deviation of expected inflation from

the central bank target. The reaction function specifies the overall amount of bonds that

agents expect the EA central bank to buy in the Home and REA secondary long-term

sovereign bond markets. Following the ECB experience, country-level purchases (both

announced and expected) are determined according to each region’s capital key, which

roughly coincides with the regional share of overall EA GDP.

In the case of the ECB, even if the size, pace, and timing of the APP changed from one

announcement to the other, the official communication has always aimed these

announcements to the achievement of a sustained adjustment in the path of inflation,

“that is consistent with its aim of achieving inflation rates below, but close to, 2% over

the medium term.” Thus, it is plausible that market participants and private analysts

have strived to map the features of each announcement into some possible form of

ECB’s “reaction function,” that connects the expected adjustment in inflation to the

expected amount of sovereign bonds’ purchases.

The reaction function should not be interpreted as describing a central bank's

systematic feedback rule regarding asset purchases. 13 The reaction function describes,

in a stylized way, agents’ expectations over unannounced future purchases, and does

neither imply nor intend to model a complete control of the central bank over long-

term interest rate developments.

Sovereign bond purchases imply that the central bank purchases long-term (domestic)

sovereign bonds in the Home and REA secondary markets to affect the long-term

13 This corresponds to actual recent policy experience by the Bank of Japan and its yield-curve control policy. See Amamiya (2017) and Jones and Kulish (2013).

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interest rates and hence the real side of the economy.

The other non-standard measure that we consider is FG. The central bank commits to

keeping the policy rate constant at its baseline (steady-state) level for a prolonged

period of time. Thereafter it follows the Taylor rule

( Rt

R )=( Rt−1

R )ρR

( Π EA ,t−3

Π EA )(1−ρR ) ρΠ

( GDPEA , t

GDPEA ,t−1 )(1−ρR ) ρGDP

. (2 )

The parameter ρR (0< ρR<1) captures inertia in interest-rate setting, while the term R

represents the steady-state gross nominal policy rate. The parameters ρΠ (ρΠ >0) and

ρGDP (ρGDP>0) are respectively the weights of EA consumer price (CPI) inflation

rate (Π EA ,t−3≡ PEA, t / PEA ,t−4) and GDP.14 The parameter Π EA is the long-run (steady-

state) constant inflation target of the central bank.

Households and firms, being forward-looking, anticipate this future change in the

monetary policy stance when making consumption and investment decisions.

2.3 Restricted households

There exists a continuum of restricted households j ', with j' ∈ (0; λR], where 0 ≤ λR≤ 1.

Their preferences are additively separable in consumption and labor effort. The generic

restricted household j' receives utility from consumption CR , t and disutility from labor

LR ,t. The household’s expected lifetime utility is

E0∑t=0

∞

βRt [ (C R,t ( j ')−hCR , t−1 )1−σ

1−σ−

LR,t ( j ' )1+φ

1+φ ](3)

14 The CPI inflation rate is a geometric average of Home and REA inflation rates, with weights equal to the correspondent (steady-state) regional GDP (as a share of the steady-state EA GDP). EA GDP is the sum of Home and REA GDPs. A similar equation describes monetary policy in the RW region.

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where E0 denotes the expectation conditional on information set at date 0; βR is the

discount factor (0 < βR < 1), 1/σ is the elasticity of intertemporal substitution (σ>0),

and 1/φ is the labor Frisch elasticity (φ>0). The parameter h (0<h<1) represents

external habit formation in consumption.15 Restricted households have access only to

the market of long-term sovereign bonds. The budget constraint is

PtL BR, t

L ( j' )−(1+κPtL )BR, t−1

L ( j' )=Π tprof ( j ')+W R ,t ( j' ) LR ,t ( j' )−Pt CR,t ( j' )−AC R,t

W ( j ' )(4 )

where BR ,tL ( j' )is the amount of domestic long-term sovereign bonds, Π t

prof ( j' ) are profits

from ownership of the Home capital producers, and W R ,t ( j ' ) is the nominal wage. The

long-term sovereign bond BR ,tL ( j ') has price Pt

L and is formalized as a perpetuity paying

an exponentially decaying coupon κ∈ (0,1¿, following Woodford (2001). The implied

gross yield to maturity at time t on the long-term bond is defined as

RtL ≡ 1

PtL +κ .(5)

Finally, households act as wage setters in a monopolistically competitive labor market.

Each household j' supplies one particular type of labor services which is an imperfect

substitute to services supplied by other households. It sets its nominal wage W R ,t ( j ' )

taking into account the labor demand and quadratic adjustment costs ACR,tW ( j' ),

AC R ,tW ( j' ) ≡

k W

2 ( W R, t ( j' )W R ,t−1 ( j ')Π t−1

αW Π EA1−α W

−1)2

W R , t LR , t(6)

where kW>0 and 0≤ αW ≤ 1 are parameters regulating wage stickiness and inertia,

respectively, and the variable Π t−1is the previous period Home consumer price

15 Following common practice in the New Keynesian literature, the assumption of cashless economy holds in the model.

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inflation rate. The adjustment costs are proportional to the per-capita (average) wage

bill of restricted households W R ,t LR,t .

Restricted households are crucial for the APP to have real effects in our model. Since

they cannot arbitrage between short-term and long-term bonds, their consumption

decisions directly depend only upon the long-term interest rate (rather than the short-

term rate). Therefore, the monetary policy authority can affect their consumption and

saving decisions by intervening in the secondary long-term sovereign bond market.

2.4 Unrestricted households

There exists a continuum of unrestricted households, indexed by j, with j ∈ (nλR; n].

These households have the same preferences as restricted households described in (2),

thus they consume and supply labor. The only difference is the discount factor,

0<βU<1, which can be different from that of restricted households (this allows us to

have a well-defined steady-state of the model).

Home unrestricted households have access to multiple financial assets (all denominated

in euros): the short-term (one-period) sovereign bond BtG ( j ), exchanged with the

domestic government and paying the EA (gross) monetary policy rate Rt; the short-

term private bond BtP ( j ), exchanged with REA unrestricted and RW households and

paying the (gross) interest rate RtP; the long-term sovereign bond BU ,t

L ( j ), exchanged

with the domestic restricted households, domestic government and, because of the

APP, the EA central bank. Thus, they have several opportunities to smooth

consumption when facing a shock. The budget constraint of the generic unrestricted

household j is

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PtL BU , t

L ( j )−(1+κPtL)BU ,t−1

L ( j )+BtG ( j )−B t−1

G ( j ) R t−1+B tP ( j )−Bt −1

P ( j ) Rt −1P (1−ϕt−1 )=Π t

P ( j )+Π tprof ( j )+W U ,t ( j ) LU ,t ( j )−Pt CU ,t ( j )−TAX t ( j )−ACU , t

W ( j )−ACU , tB ( j ) .(7)

The dividends Π tP ( j )are from ownership of domestic monopolistic firms (claims to

firms’ profits are not internationally tradable). The term ϕt−1 represents an exponential

adjustment costs, needed to stabilize the position in the internationally traded bond.16

The variable profit Π tprof ( j ) denotes profits from ownership of the Home capital

producers. The term TAX t ( j ) represents lump-sum taxes. Unrestricted households

supply labor services under monopolistic competition and face quadratic adjustment

costs ACU ,tW ( j ) when setting nominal wages (the cost is similar to the one paid by

restricted households). They also pay adjustment costs ACU ,tB ( j ) on long-term

sovereign bond holdings.17

First order conditions imply no-arbitrage conditions for the unrestricted households.

Thus, in equilibrium the interest rates paid by the different bonds are expected to be

equal to the monetary policy rate, net of the spreads induced by the longer maturity and

the adjustment costs.

2.5 Capital goods producers

There exists a continuum of mass 0<n<1 of firms, indexed by e, that produce private

16 The adjustment cost is defined as ϕt ≡ ϕb1

exp (ϕb2 (BtP−BP ))−1

exp (ϕb 2 (B tP−BP ))+1

, where ϕb 1 , ϕb 2>0 are parameters, BtP

and BPare the period t and steady-state positions of the representative Home unrestricted household, respectively. Both are taken as given in the maximization problem. A similar cost holds for the RW household.17 We assume a standard quadratic form for the adjustment cost, that is,

ACU ,tB ( j )≡

ϕbL

2 ( PtL BU , t

L ( j )−PL BUL )2(8)

where ϕb L>0 is a parameter and PL BUL is the (symmetric) steady-state value of the long-term sovereign bond. The

adjustment cost guarantees that the bond holdings follow a stationary process and that the economy converges to the steady state.

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physical capital. Each firm e optimally chooses capital K t (e) and investment I t(e ) to

maximize profits subject to the law of capital accumulation, the adjustment costs on

investment, and taking prices as given. The law of motion of capital accumulation is

K t (e )= (1−δ ) K t−1 (e )+(1−AC I , t (e )) I t (e ) ,(9)

where 0<δ<1 is the depreciation rate. The adjustment cost on investment AC I ,t(e) is

AC I ,t (e )≡ φI2 ( I t (e )

It−1 (e )−1)

2

I t (e )(10)

where φI >0 is a parameter. Capital producers rent the existing physical capital stock

K t−1(e)at the nominal rate Rk , t to domestic firms producing intermediate tradable and

non-tradable goods. Investment is a final non-tradable good, composed of intermediate

tradable (domestic and imported) and non-tradable intermediate goods. Capital

producers buy it in the corresponding market at price P I.18 Because of the adjustment

costs on investment, a “Tobin’s Q” holds. When maximizing profits with respect to

capital and investment, capital producers discount profits using the stochastic discount

rates of restricted and unrestricted households, aggregated according to the

corresponding population shares.

2.6 Fiscal authority and supply of long-term sovereign bonds

Fiscal policy is set at the regional level. In the Home region there is a government

budget constraint. Public debt consists of two bonds issued to domestic households: the

(short-term) one-period nominal bond, that pays the monetary policy rate and is issued

18 Similarly to the consumption basket, the investment bundle is a composite of tradable and non-tradable goods. The composition of consumption and investment goods can be different.

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to domestic unrestricted households; the (long-term) bond, issued to domestic

unrestricted and restricted households and, because of the non-standard monetary

policy measures, to the EA central bank.

The Home government follows a fiscal rule that calls for an increase (reduction) in

lump-sum taxes (as a ratio to GDP) whenever the current-period short-term public debt

(as a ratio to GDP) is above (below) the target and increasing over time.19 We assume

that the long-term sovereign bond is kept constant at its steady-state level, so that

changes in the long-term interest rate are entirely due to the non-standard monetary

policy measures.20

2.7 Equilibrium

In each country the initial asset positions, preferences, technologies, and budget

constraints are the same for households belonging to the same type and firms

belonging to the same sector.

Moreover, profits from ownership of domestic monopolistically competitive firms are

equally shared among unrestricted households. Profits from ownership of domestic

19 We choose lump-sum taxes to stabilize public finance as they are non-distortionary (i.e., they do not enter the first-order conditions of households and firms). Lump-sum taxes are paid by unrestricted households only. In this way we are able to isolate the response of restricted households to the APP from the indirect fiscal adjustments implied by the program. However, the Ricardian equivalence does not hold because restricted households hold long-term sovereign bonds but are not subject to lump-sum taxes. Thus, our assumption on the distribution of lump-sum taxes or, equivalently, on the initial distribution of public debt implies that sovereign bond holdings are net wealth.20 We include only the short-term debt in the Home fiscal rule for two reasons. First, we hold the supply of long-term government bonds fixed, so as to isolate the direct demand effects of the APP. Second, we need the fiscal rule to stabilize the short-term debt and, given that the long-term component is exogenous, the overall public debt. We take into account this distinction when we calibrate the model and more specifically the fiscal target. A similar fiscal rule holds in the REA. In the RW the rule holds for the overall public debt, as there is no distinction between short- and long-term domestic sovereign bonds.

19

capital producers are distributed to restricted and unrestricted households according to

the corresponding population shares, and are equally shared within each type. Thus, we

consider the representative household for each type (restricted and unrestricted). We

also have a representative firm for each sector (final non-tradable, intermediate

tradable, and intermediate non-tradable) and a representative capital producer in each

EA region. The implied symmetric equilibrium is a sequence of allocations and prices

such that, given initial conditions and considered shocks, households and firms satisfy

their corresponding first order conditions, the monetary rules, the fiscal rules, the EA

central bank reaction function, and the government budget constraints hold, and all

markets clear.

2.8 Taking the model to the data

The model is taken to quarterly data. The key equation is the reaction function of the

central bank (see eq. 1), which is estimated. Specifically, we estimate the elasticity of

expected purchases to the expected inflation gap using data on (a) additional

announced purchases and (b) the inflation gap in correspondence of the considered

announcement. Data are reported in Table 1

Table 1. Reaction function. Data

Announcement date

Inflation gap (pp)

Purchases (€ bn) / Month

Total additional purchases (€ bn)

January 2015 0.7 60 1080December 2015 0.3 60 350

March 2016 0.2 80 240

20

December 2016 0.5 60 540October 2017 0.4 30 270

The inflation gap is the difference between a target of 1.5% and the core inflation expected (within the Eurosystem's official projection exercises) for the quarter of the announcement in the quarter immediately before (2014Q4 for January 2015, 2015Q4 for December 2015, 2016Q1 for March 2016, 2016Q4 for December 2016, and 2017Q3 for October 2017).

Figure 1 reports the four monetary policy announcements regarding the APP,

highlighting the linear relationship between announced volumes of purchases and the

inflation gap. Table 2 contains the estimated parameters of the regression analysis.

Figure 1. Empirical relation between APP purchases and inflation gaps

21

Jan 2015

Dec 2015Mar 2016

Dec 2016

Oct 2017

0

200

400

600

800

1000

1200

0 0.2 0.4 0.6 0.8 1

Table 2. Reaction function. Estimates

Dependent variable: Purchases (€bn) / Month

Inflation gap (pp) 118.615***(23.234)

Observations 5R-squared 0.785Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

The coefficient is estimated to be positive and significant. Consistent with the above

estimates, the parameters of the central bank reaction function are set so as to

correspond to a quarterly flow of additional net purchases equal to € 360 billion, or

10% of quarterly EA GDP, for each pp deviation of EA annualized inflation from the

target. This amount is in line with the estimates reported in Skolimowski (2017) and

based on data on Eurosystem APP purchases and EA inflation gaps.21

21 Skolimowski (2017) also includes data on the targeted longer-term refinancing operations (TLTRO) in the

22

We also provide evidence that, by linking APP and FG announcements,

communication shaped expectations about the subsequent monetary policy rates lift-

off. In October 2017 the ECB extended the net purchases past the end of the year,

signaling that, starting in January 2018, purchases would “continue at a monthly pace

of €30 billion until the end of September 2018, or beyond, if necessary, and in any case

until the Governing Council sees a sustained adjustment in the path of inflation

consistent with its inflation aim.”22 Moreover, the expected path of the policy rate was

linked to the intended horizon of the net asset purchases. In fact, concerning the key

ECB interest rates, the (so-called “well past” FG) statement said that the ECB would

“expect them to remain at their present levels for an extended period of time, and well

past the horizon of our net asset purchases.”

Figure 2 reports evidence of the effects of the “well past” FG announcement on

expectations about the future monetary policy rate path. The day of the announcement

(October 26, 2017), the path of 3-month Euribor rates derived from futures contracts (a

widely used market-based measure of expected future monetary policy rate) shifted

outward. The markets forecasted the lift-off of monetary policy rates (10 basis points

above the spot level, dashed black line) to begin in the first quarter of 2019 (red line),

while the day before the announcement markets had forecasted the first lift-off in the

last quarter of 2018 (blue line).

Figure 2. October 2017 announcement and expectations about the monetary policy rate

estimation. When we simulate the model, the amounts of purchases of Home and REA long-term sovereign bonds are proportional to the corresponding EA GDP share.22 See Praet (2018a).

23

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

Spot Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19 Mar-20 Jun-20

25/10/2017

26/10/2017

In our analysis the response of the interest rate on long-term sovereign bonds to the

central bank purchases plays a key role. We use the existing evidence for the EA

reported in Altavilla, Carboni, & Motto (2015) to calibrate the parameter regulating the

adjustment costs paid by the unrestricted household on deviations of long-term

sovereign bond positions from steady-state levels. We set them to 0.0005 in both Home

and REA blocs ( the parameters regulating the adjustment cost on the internationally

traded private bond position paid by Home unrestricted households and RW

households are set to 0.0055).

Turning to the rest of the model parameters, Home represents a generic EA Member

State, relatively small (its GDP is 17% of EA GDP) and open (the import-to-GDP ratio

is 26%).23 The sizes of Home and REA GDPs as shares of world GDP are set to 3%

and to 15%. We deliberately keep the two regions relatively symmetric to get a

transparent transmission mechanism of the simulated shocks. We set some parameter

23 Details and tables reporting the calibration are in the working paper version (Burlon, Notarpietro, & Pisani, 2018).

24

values so that steady-state ratios (private consumption-, public consumption-, and

investment-to-GDP ratios) are consistent with EA national account data. For the

remaining parameters we resort to previous studies and estimates available in the

literature.

The short-term interest rate is equal to 0.24% on an annual basis. The spread between

short- and long-term bond is equal to 1.7 percentage points (pp). In each EA region the

share of restricted households is set to 0.10 and, thus, the share of unrestricted

households to 0.90. The (resulting) share of capital producers owned by restricted

households is set to 0.10, which is equal to the share of restricted households in the

population.

The chosen shares allow, in correspondence of a standard monetary policy shock and

taking the calibration of other parameters as given, to (i) obtain impulse responses in

line with estimates prevailing in the literature, especially with respect to the relative

response of investment and total consumption and (ii) align the responses of

consumption of restricted households with those of unrestricted households.24

Short-term public debt (ratio to yearly GDP) is set to 8% for both Home and REA.

Long-term public debt is set to 93.3% of GDP for both Home and REA. Thus, total

public debt as a share of GDP is 101% in both Home and REA. Such figure is slightly

larger than the average ratio for the EA, which has settled around 90% since 2012. The

duration of the long-term sovereign bond is equal to the average duration of EA long-

term sovereign bonds (8 years).

We assume that in each country long-term sovereign bond holdings are equally shared

24 The resulting share of consumption by unrestricted households is around 0.93 of total consumption and the share by restricted households is 0.07, in both EA countries.

25

between unrestricted and restricted households.

The central bank of the EA uses the policy rate to target the contemporaneous EA-wide

consumer price inflation (the corresponding parameter is set to 1.7) and the output

growth (the parameter is set to 0.1). The interest rate is set in an inertial way and hence

its previous-period value enters the rule with a weight equal to 0.87. The values are

identical for the corresponding parameters of the Taylor rule in the RW.

The chosen calibration yields impulse response functions to a standard monetary policy

shock (+0.25 basis points, bp) for GDP and inflation in each EA region that are in line

with those of the workhorse estimated models of the EA in the literature.25

3 Simulated scenariosWe consider four scenarios. They are all simulated under perfect foresight, i.e., there is

no uncertainty around the expected future values of the model variables.

In constructing the economic environment at the beginning of our simulations we

assume an initial gap of 0.1 pp between the inflation target and actual annualized

inflation. The value of 0.1 aims at representing a macroeconomic outlook characterized

by an inflation rate that is still not aligned with the target of the central bank in the

foreseeable future, at least not in absence of the monetary policy stimulus. In one

scenario (the fourth), we assume that an unexpected negative EA aggregate demand

shock affects the EA economy after the APP announcement. In all scenarios the central

25 See, for example, the models of the EA economy NAWM (Christoffel, Coenen, & Warne, 2008) and EAGLE (Gomes, Jacquinot, & Pisani, 2010). See also the model GEM (Pesenti 2008).

26

bank announcements are fully credible. In the first scenario, labeled “Full

announcement,” we assume that the central bank makes an announcement of future

purchases over a fully specified period of time and, in particular, it announces the end

date of the programme.26

We calibrate the size of the announced future purchases to mimic the October 2017

announcement by the ECB of future additional purchases between January and

September 2018. This consists of € 30 billion per month worth of additional purchases

for three quarters (from 2018Q1 to 2018Q3), with no additional purchases in the first

period after the announcement (2017Q4). Moreover, we assume that the FG keeps the

policy rate at the level prevailing before the announcement until the end of the

purchases, that is, for 4 quarters (until 2018Q3). Thereafter, the monetary policy rate

follows the Taylor rule (see Eq. 2).

In the second scenario, labeled “Open-ended announcement,” the ECB does not

announce an end date of the APP and, moreover, announces that it keeps the possibility

of further prolonging the purchases beyond 2018Q3. In this case, agents, as in the

previous scenario, fully believe the announced purchases (from 2018Q1 to 2018Q3).

Moreover, they know the central bank reaction function (see Eq. 1) and use it to form

expectations about additional unannounced future purchases on the basis of the

expected inflation gap. We assume, in a deliberately conservative way, that the reaction

function is active for two quarters (2018Q4 and 2019Q1). Expectations on the FG on

the policy rate are the same as in the first scenario. In the third scenario, labeled

“Open-ended announcement with prolonged FG,” we assume that the same conditions

26 For simplicity, in all simulations the decay of the outstanding amounts is expected to start immediately after the end of the purchases. Thus, we abstract from the effects of the announcement on the reinvestment policy which is an additional possible instrument in the APP toolbox.

27

of the second scenario hold but for the FG on the policy rate, which keeps the policy

rate unchanged also in two additional periods: 2018Q4 and 2019Q1. This assumption

on the FG is consistent with the current wording of ECB official communication,

according to which which the first rate hike would occur only “well past the horizon”

of net asset purchases (Draghi & Constancio, 2017).

In the fourth scenario, labeled “Negative demand shock,” we simulate a negative EA-

wide aggregate demand shock, which induces a reduction in EA consumption and

investment, calibrated to induce a drop in EA annualized in inflation of around 0.1pp in

the average of the first year of simulation, so to double the size of the inflation gap.

The shock hits the EA economy after the (full or open-ended) announcement.

4 Results

4.1 Full announcement

Figure 3 reports the quarterly response of key EA-wide variables in the case of full

announcement, i.e., when the central bank announces the amounts and pace of future

purchases and, crucially for the purposes of our analysis, the end date of the

programme.27 The announcement consists of € 30 billion per month worth of additional

Figure 3: Full announcement. EA variables.

27 In what follows we do not report the details by country because the impacts are rather symmetric. They are available upon request.

28

0 5 10 15 20 25 30 35 400

2

4CB holdings

0 5 10 15 20 25 30 35 400.22

0.24

0.26Policy rate

0 5 10 15 20 25 30 35 40-0.1

0

0.1Long term int. rate

0 5 10 15 20 25 30 35 40-0.05

0

0.05Exchange rate (+=appr.)

0 5 10 15 20 25 30 35 400

0.05

0.1GDP

0 5 10 15 20 25 30 35 40-0.05

0

0.05CPI inflation

Notes: Quarters on the horizontal axis. On the vertical axis, % deviations from the baseline for GDP and exchange

rate (positive values correspond to an appreciation of the euro); annualized pp deviations from the baseline for

inflation and long-term interest rate; levels for the policy rate; pp deviations from the baseline for the central bank

(CB) holdings measured as % of EA annual GDP.

purchases for three quarters (from 2018Q1 to 2018Q3), with no additional purchases in

the first period after the announcement (2017Q4). The overall announced purchases

amount to roughly 2.5% of annual EA GDP. Moreover, we assume FG, i.e., the central

bank announces to keep the policy rate at the level prevailing before the announcement

(the baseline, steady-state level in our model) until the end of the purchases (i.e., for 4

quarters, until 2018Q3). Thereafter, the monetary policy rate follows the Taylor rule.

As a result of the announced purchases, the interest rate on long-term sovereign bonds

decreases by 8bp on impact and, thereafter, gradually returns to its baseline level (the

size of the initial decrease is in line with the range of estimates in the existing literature

once we rescale the size of the shock). The policy rate is constant at its baseline

29

(steady-state) level during the first year, and increases (by a very small amount)

starting from the fifth quarter. The nominal exchange rate of the euro slightly

depreciates on impact, consistent with the uncovered interest parity condition, which

holds in the model, and the implemented expansionary monetary policy measures.

The lower long-term interest rate induces restricted households to increase

consumption and investment in physical capital (not reported to save on space). The

FG on short-term interest rates favors unrestricted households’ aggregate demand.

Following the higher domestic aggregate demand, EA GDP persistently increases

above its baseline level (by 0.06% at the peak). Similarly, the CPI inflation rate

increases (by 3bp at the peak).28

Overall, the announced measures are expansionary, as agents make consumption and

investment decisions on the basis of their expectations about the expansion of the

central bank's balance sheet and the duration of the FG. In other terms, agents’

expectations about the future path of interest rates fully reflects the (credible)

announcement of the central bank about the intended accommodative monetary policy

stance.

4.2 Open-ended announcement

In this scenario the central bank does not announce an end date of the APP. Instead, it

announces that it keeps the possibility of further prolonging the purchases beyond

2018Q3 conditionally on inflation developments. Agents, as in the scenario reported in

28 The dynamics of international trade (not reported to save on space) is characterized by an increase in imports, driven mostly by the relatively large increase in investment in physical capital, which has a large imported component (this effect on imports dominates the negative one associated with the depreciation of the exchange rate). Exports slightly increase in the medium run.

30

the previous section, fully believe the announced purchases (implemented from

2018Q1 to 2018Q3). Expectations on the FG are the same as in the first scenario (i.e.,

the monetary policy rate is kept constant during the initial 4 quarters, until 2018Q3,

and, thereafter, it follows the Taylor rule).

Crucially, and different from the “Full announcement” scenario, it is now assumed that

agents form their expectations about additional unannounced future purchases

according to the reaction function (Eq. 1), that links expected purchases to the inflation

gap. We assume, in a deliberately conservative way, that the function is active for two

quarters, 2018Q4 and 2019Q1 (we investigate the effects of the function being active

for more periods in the next sections).

Figure 4 reports the results and compare them to those of the “Full announcement”

scenario.

Households and firms now expect more purchases than in the “Full announcement”

scenario. The reason for the larger expected purchases relies on the reaction function.

Purchases announced by the central bank, that feed the model simulation, are not large

enough to close the initial inflation gap. Thus, agents expect additional future

purchases, in 2018Q4 and 2019Q1, to further reduce the inflation gap, even if they

were not announced. The endogenous profile of expected unannounced future

purchases proceeds beyond September 2018 at roughly the same pace as the one fully

announced up to that date (around € 30 billion per month).

Figure 4: Open-ended announcement. EA variables.

31

0 5 10 15 20 25 30 35 400

2

4CB holdings

0 5 10 15 20 25 30 35 400.2

0.25

0.3Policy rate

0 5 10 15 20 25 30 35 40-0.2

0


0 5 10 15 20 25 30 35 40-0.1

0


0 5 10 15 20 25 30 35 400

0.1

0.2GDP

0 5 10 15 20 25 30 35 40-0.1

0

0.1CPI inflation

Full announcementOpen-ended





Relative to the “Full announcement” scenario, the macroeconomic impact is larger,

because of the additional future (expected) purchases. Following the larger increase in

the expected central bank’s demand of sovereign bonds, long-term rates decrease by an

additional 6bp. Consistent with the more expansionary stance, the exchange rate

depreciates to a larger extent. The additional decrease in the long-term interest rates

favors a larger increase in aggregate demand for consumption and investment. EA

GDP reaches 0.1% above the baseline level by the end of 2018, and the inflation rate

closes half the initial gap, at 5bp above the baseline level by the end of 2018. The FG

effectiveness is also indirectly enhanced by the additional expected purchases, because

the short-term real interest rates decrease to a larger extent, consistent with the larger

32

increase in inflation and the expectations of constant nominal rates in the initial

quarters. As a result, the policy rate increases to a larger extent in the subsequent

quarters, consistent with the Taylor rule (Eq. 2) that has to stabilize a larger increase in

inflation and GDP. Overall, the additional expansionary effects of the open-ended

announcement are non-negligible, even if the additional purchases are relatively small

(around € 25 billion per month) and the reaction function is active for two quarters

only (six months).

The simulations lead to a conclusion that is relevant from a policy perspective: agents’

expectations can be relevant for the relative macroeconomic effectiveness of closed- vs

open-ended announcements. The latter are more expansionary than the former if agents

expect that the central bank will implement further measures if the ones announced are

not sufficient to achieve the target. In this respect, not only the central bank’s past

actions are important, but a crucial element is the central bank’s confirmation and

communication that the duration of the programme and inflation dynamics are

intertwined.

Moreover, as we show in the next section, the effects are larger if the reaction function

is active for more periods, implying not only more additional expected purchases but

also a longer duration of the FG on the monetary policy rate (so called “signaling”

effect of the purchase programme).

4.3 Open-ended announcement with prolonged FG

In this Section we evaluate the interaction between the open-ended and FG

announcements. In particular, we focus on announced references by the central bank to

33

continue to expect key policy rates to remain at their present levels “for an extended

period of time, and well past the horizon” of net asset purchases.29 In this case, agents

expect a longer FG to accompany the additional purchases commanded by the reaction

function.

For expected purchases, the same conditions of the open-ended scenario reported in the

previous section hold.

For the FG on the policy rate, the central bank announces that it will keep the policy

rate unchanged also in the two additional periods of expected purchases induced by the

open-ended announcement, that is, in 2018Q4 and 2019Q1.

Figure 5 shows the results. The expected extension of the FG induces lower real short-

term interest rates, which favor aggregate demand for consumption and investment in

physical capital by unrestricted households. There is a larger increase in GDP and its

components. As the announcement with the prolonged FG proves to be more

expansionary, the impact on inflation is larger (around 7bp). Thus, the inflation gap at

the onset of the open-ended programme is smaller and, consistently, the endogenous

reaction function-based determination of the additional future purchases by the central

bank leads to an expected profile of future holdings that is actually lower than the

profile that is expected in absence of a prolonged FG. The expected peak holdings

reach at most 3.5% of annual EA GDP instead of the 4%, which is reached when

agents do not associate an extension of the FG to the extension of the APP. Consistent

with the lower expected stock of central bank’s purchases, the long-term interest rates

decrease by a slightly lower amount.

29 See Draghi and Constancio (2017).

34

Figure 5: Open-ended announcement with prolonged FG. EA variables.

0 5 10 15 20 25 30 35 400

2

4CB holdings

0 5 10 15 20 25 30 35 400.2

0.25

0.3Policy rate

0 5 10 15 20 25 30 35 40-0.2

0


0 5 10 15 20 25 30 35 40-0.2

0


0 5 10 15 20 25 30 35 400

0.1

0.2GDP

0 5 10 15 20 25 30 35 40-0.1

0

0.1CPI inflation

Full announcementOpen-endedOpen-ended with FG (6 q)





We further investigate the quantitative effects of the open-ended programme by

assuming that the agents expect not only a longer FG, but also that unannounced

purchases will last for more periods than those considered in the previous simulations.

Specifically, it is assumed that agents expect three additional quarters of unannounced

purchases (instead of two as in previous simulations) and three additional quarters of

FG (seven quarters, from 2017Q4 to 2019Q2). We report the results in Figure 6.

Figure 6: Open-ended: additional periods of purchases and FG. EA variables.

35

0 5 10 15 20 25 30 35 400

2

4CB holdings

0 5 10 15 20 25 30 35 400.2

0.25

0.3Policy rate

0 5 10 15 20 25 30 35 40-0.2

0


0 5 10 15 20 25 30 35 40-0.2

0


0 5 10 15 20 25 30 35 400

0.1

0.2GDP

0 5 10 15 20 25 30 35 40-0.2

0

0.2CPI inflation

Open-ended with FG (6 q)Open-ended with FG (7 q)





Once we extend the open-ended periods from two to three, the front-loading of the

macroeconomic impact leads to an inflation rate that reaches 0.1pp above the baseline,

thus closing the initial gap in the first year. The higher resulting inflation rate implies

that the holdings in 2019Q1 are lower than in the case with only two open-ended

periods. GDP increases more than in the previous cases, as the larger expected

purchases and the longer expected duration of FG induce a further expansion in private

expenditure. Similarly, the macroeconomic effectiveness of FG is enhanced by the

additional expected purchases, because the implied higher (expected) inflation reduces

the short-term real interest rates, given that their (EA-wide) nominal counterpart is kept

constant.

36

Overall, the reported results suggest that the macroeconomic effectiveness of the open-

ended announcements can be enhanced if those announcements are able to

systematically and credibly link agents’ expectations on future purchases to

expectations on the duration of FG. Moreover, the effectiveness of FG in stimulating

the economy can also be enhanced by the expected future purchases, as long as the

latter are large enough to stimulate expected inflation in a non-negligible way.30

4.4 Negative demand shock

A negative demand shock can move inflation further away from the monetary policy

target. In what follows we compare the effectiveness of the full- and open-ended

announcement in counteracting the recessionary effects of a negative demand shock

that materializes immediately after the (alternative) announcements.31

We present the results of these simulations in Figure 7.

In the first simulation (labelled as “Shock,” dash-dotted black line in the charts), a

negative demand shock reduces EA GDP by almost 0.5% and the EA inflation rate by

0.1 annualized pp at the trough. We consider the following alternative scenarios on top

of the previous one: in the second (“Shock+full announcement,” solid black line),

Figure 7: Negative EA aggregate demand shock. EA variables.30 The size of additional expansionary effects in the case of prolonged FG is consistent with recent contributions on the macroeconomic effectiveness of FG. See Del Negro, Giannoni, & Patterson, (2012). In our model the decisions of restricted households are not directly affected by the short-term interest rates. Thus, it is likely that the effectiveness of FG is, in our model, lower than in the standard representative agent New Keynesian model.31 The negative demand shock is a combination of negative consumption preference and investment specific shocks in the two EA regions and in the RW that feed the model in the initial three quarters.

37

0 5 10 15 20 25 30 35 40-5

0

5CB holdings

0 5 10 15 20 25 30 35 400.1

0.2

0.3Policy rate

0 5 10 15 20 25 30 35 40-0.2

0


0 5 10 15 20 25 30 35 40-0.02

0


0 5 10 15 20 25 30 35 40-0.5

0

0.5GDP

0 5 10 15 20 25 30 35 40-0.2

0

0.2CPI inflation

ShockShock + Full announcementShock + Open-ended (2 q)Shock + Open-ended (3 q)





full announcement of the additional APP purchases until September 2018; in the third,

open-ended announcement with prolonged FG until 2019Q1 (“Shock+open-ended

(2q),” dashed red line) and, finally, in the fourth, open-ended announcement with

prolonged FG until 2019Q3 (“Shock+open-ended (4q),” green line).

All announcements help contain the worsening of macroeconomic conditions and, at

the same time, limit the fall in the short-term policy rate.

The open-ended announcement with FG until 2019Q1 is more accommodative than the

full announcement, as agents expect higher purchases also in the two quarters of the

open-ended leg of the programme. Specifically, the negative effects on inflation of the

negative demand shock widen the initial inflation gap. Given the reaction function,

38

agents expect the central bank to further increase the bond purchases beyond the

announced ones. Thus, long-term interest rates decrease to a larger extent, further

stimulating economic conditions. The improvements in inflation and economic activity

(i.e., the faster economic recovery) imply a steeper subsequent rise in the short-term

monetary policy rate.32

The macroeconomic effectiveness of the open-ended announcement with FG in

counterbalancing the recessionary shock is further enhanced if agents expect the

additional purchases and FG to last for longer.

Overall, our results clearly show that an open-ended programme is more effective than

a full-announcement in stabilizing macroeconomic conditions in the face of unexpected

shocks that drive inflation further below the target. This suggests that an open-ended

announcement is particularly desirable if economic conditions are uncertain, because,

as long as that type of communication induces agents to believe in a reaction of the

central bank, it helps stabilize expectations about future macroeconomic outcomes.

5 ConclusionWe have used a large-scale New Keynesian DSGE model for the EA to evaluate the

benefits of an open-ended APP when the inflation rate is not yet aligned with the

monetary policy target over the medium term. We have showed that an open-ended

APP helps maintain an accommodative monetary policy stance. Eschewing a full

announcement of the future path of purchases increases the effectiveness of the 32 We do not consider the zero lower bound (ZLB) constraint on the monetary policy rate, but the steeper rise in the policy rate that we obtain under the open-ended programme suggests that the latter should favor an earlier exit from the ZLB. This further corroborates the greater effectiveness of the open-ended programme in stimulating macroeconomic conditions. We leave the analysis of the ZLB for future research.

39

committed future purchases by managing expectations over unannounced future

purchases through appropriate and systematic communication. Moreover, the

effectiveness increases even further if the central bank communication also induces a

correlation in agents’ expectations between the continuation of net future purchases

and that of the FG on policy rates. Finally, an open-ended APP may prove all the more

adequate if additional, unforeseen negative shocks stave off even further the

achievement of the inflation target over the medium term.

From a policy perspective, our paper emphasizes the role of communication and its

impact on agents’ expectations. Communication, by allowing the central bank to

manage expectations of economic agents, becomes particularly relevant when

macroeconomic conditions and the monetary policy tools are not the standard ones and,

thus, are not well known by economic agents and/or their functioning is very difficult

to explain to the public. An appropriate communication of the non-standard monetary

policy measures should ensure consistency over time, clarify the state contingency of

the policy stance, and provide clarity on the use of specific tools in a multi-instrument

context. In this way, the central bank can reduce uncertainty and, thus, shape

expectations in such a way to maximize the effectiveness of the policy measures

themselves.

From a more theoretical perspective, in this paper we have not assessed the role of

announcing a reinvestment policy, which in principle could enhance the effectiveness

of the open-ended APP, as long as agents anticipate a larger size of the central bank

balance sheet. We leave this issue for future research.

40

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