This paper uses a model with financial market segmentation to assess the macroeconomic effects of a reduction in the stock of long-term sovereign bonds held for monetary policy purposes by a central bank, as the latter does not reinvest the principal payments from maturing bonds. The analysis considers alternative assumptions on the reaction of financial markets.
The portfolio reduction lowers economic activity and inflation via a rise in long-term interest rates. These effects are amplified if financial markets overreact in the aftermath of the announcement of the reduction.
