This paper analyzes optimal asset-purchase and exit policies in a macroeconomic model with banks facing precautionary liquidity regulations (Liquidity Stress Testing and Leverage Coverage Ratio) and balance sheet costs. QE accelerates recoveries after productivity, liquidity, and bank net worth shocks by inflating bond prices and restoring bank net worth. It becomes more powerful as it provides reserves and boosts intermediation when the LCR constraint binds. The optimal exit strategy is gradual whenever the LCR constraint binds. However, a fast QT is costless and expansionary when liquidity is abundant as it drives the banks to substitute bonds for working capital.
Motivated by the inflation surge experienced during 2021-2023 and the subsequent trial and error of tightened monetary policy, we construct a DSGE model with producer-supplier contracting frictions. This model sheds light on the upper bound of interest rates preventing excessive tightening from leading to a recession. Similar to the concept of a reversal interest rate proposed by Abadi, Brunnermeier, and Koby (2022) that establishes the effective lower bound on expansionary monetary policy, our upper bound complements the Taylor rule by considering firm dynamics at the micro-level. Specifically, our model includes a final good sector engaged in one-period contracting regarding the price and quantity of goods supplied by monopolistic suppliers. As the final good sector is unable to observe its suppliers’ productivity, moral hazard prevents efficient renegotiation when an unexpected productivity shock affects a portion of the suppliers. Due to the risk of failed renegotiation and the high cost of meeting contractual obligations, firms may find it optimal to declare bankruptcy and exit the market, depending on updated valuation by the shareholders. A tightened monetary policy aimed at price stabilization following a supply shock impacts the shareholders’ investment trade-off by altering opportunity costs and firm valuations, potentially leading to increased firm exits and amplification of supply shocks. The distribution of firms plays a key role in quantitatively determining the central bank’s leeway in stabilizing prices without compromising welfare compared to laissez-faire conditions.