Central Bank Exit Strategies: Domestic Transmission and International Spillovers Christopher Erceg, Marcin Kolasa, Jesper Lindé, Haroon Mumtaz and Pawel Zabczyk WP/24/73IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed i n IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2024 MAR INTERNATIONAL MONETARY FUND ii © 2024 International Monetary Fund WP/24/73 IMF Working Paper Monetary and Capital Markets Department Central Bank Exit Strategies: Domestic Transmission and International Spillovers Christopher Erceg, Marcin Kolasa, Jesper Lindé, Haroon Mumtaz and Pawel Zabczyk*1 Authorized for distribution by Christopher Erceg March 2024 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: We study alternative approaches to the withdrawal of prolonged unconventional monetary stimulus (“exit strategies”) by central banks in large, advanced economies. We first show empirically that large-scale asset purchases affect the exchange rate and domestic and foreign term premiums more strongly than conventional short-term policy rate changes when normalizing by the effects on domestic GDP. We then build a two-country New Keynesian model that features segmented bond markets, cognitive discounting and strategic complementarities in price setting that is consistent with these findings. The model implies that quantitative easing (QE) is the only effective way to provide monetary stimulus when policy rates are persistently constrained by the effective lower bound, and that QE is likely to have larger domestic output effects than quantitative tightening (QT). We demonstrate that “exit strategies” by large advanced economies that rely heavily on QT can trigger sizeable inflation-output tradeoffs in foreign recipient economies through the exchange rate and term premium channels. We also show that these tradeoffs are likely to be stronger in emerging market economies, especially those with fixed exchange rates. JEL Classification Numbers: C54, E52, E58, F41 Keywords: Monetary Policy; Quantitative Easing; International Spillovers Author’s E-Mail Address: CErceg@IMF.org, MKolasa@IMF.org, JLinde@IMF.org, H.Mumtaz@qmul.ac.uk, and PZabczyk@IMF.org1* Special thanks to Luis Brandao-Marques, our co-author on a related research project, our conference discussants Luca Fornaro and Amina Enkhbold, our internal IMF reviewers Damien Capelle, Abolfazl Rezghi, and Vina Nguyen, as well as Mustafa Caylan and Sheheryar Malik for sharing their GFSR term premium estimates. We would also like to thank Tobias Adrian, Marco Casiraghi, Philipp Engler, Gianluigi Ferrucci, Gita Gopinath, David Hofman, Roland Meeks, Fumitaka Nakamura, Grzegorz Wesolowski, participants at the 2023 CEPR Summer Symposium in International Macroeconomics, and the 2023 CEBRA Annual Meeting, as well as seminars and workshops organized by the IMF. Kaili Chen and Rebecca Huang provided excellent research assistance. The views expressed here are ours and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. Contents1. Introduction12. Empirical Results52.1. Monetary Policy Shocks52.2. Estimation and Specification62.3. Transmission of Conventional Monetary Policy and LSAPs63. Model and Calibration93.1. Households103.2. Firms123.3. Government133.4. Market Clearing Conditions143.5. Exogenous shocks153.6. Calibration153.7. Solution184. Transmission of Asset Purchases and Interest Rate Policy in the Model194.1. Comparing the Effects of QT and Conventional Tightening194.2. Effects of Forward Guidance and QE in a Liquidity Trap224.3. Comparing the Effects of QE and QT245. International Spillovers from Central Bank Exit Strategies265.1. The Inflation Surge Scenario265.2. Spillovers from Alternative Exit Strategies275.3. The Role of Policy Conduct in Recipient Economies296. Conclusions31References34Appendix A. Additional Empirical Results38Appendix B. Estimation Details39Appendix C. The Role of Asset Market Segmentation40Appendix D. Term Premium and Duration41Appendix E. The Government and Central Bank Balance Sheets42Appendix F. Extended Model Equations47Appendix G. The Linear Run-Off Specification48Appendix H. The Impact of Cognitive Discounting and Kimball Preferences49iii 1.IntroductionSince the global financial crisis, central banks in major economies – the US Federal Reserve,European Central Bank (ECB), Bank of Japan and the Bank of England – have undertaken si