Managing Monetary Policy Normalization

Abstract This paper develops a framework for monetary policy normalization in which liquidity conditions shape aggregate demand through a liquidity channel. The model implies that central bank balance sheet operations can stabilize demand even away from the zero lower bound, making reserves an independent policy instrument alongside interest rates. Optimal balance sheet size therefore depends not only on private reserve demand, but also on fiscal interactions and liquidity management. Following shocks that generate a liquidity trap, optimal policy expands reserves at the lower bound, initiates quantitative tightening before rate liftoff, and normalizes rates and reserves together, clarifying balance sheets’ stabilization role.