In macroeconomic models, the behavior of the government is often exogenous, except for its budget constraint, which relates the stock of assets (money and bonds) and net government revenue (taxes minus transfers and interest payments on national debt) to the level of government spending. In such formulations the government is a consolidation of the treasury and the central bank, and open-market operations are entirely exogenous.

This level of aggregation and exogenous specification of government behavior omits some of the determinants of the short-run values of crucial macroeconomic variables, such as asset prices (e.g., exchange rates and interest rates).

In this chapter, as a first step toward overcoming these shortcomings, the government is disaggregated into the treasury and the central bank. The behavior of the treasury is exogenous, as mentioned. In contrast, the behavior of the central bank is endogenous, the outcome of portfolio optimization subject to endowments and stabilization constraints.

The implications of portfolio optimization by the central bank are examined for the efficacy of the treasury's policies in the short run. It is demonstrated that the impact of monetary and fiscal policies on the exchange rate, interest rate, and employment are conditional on the characterization of the short-run equilibrium in which the economy finds itself. The fact that the effects on employment are conditional on the initial equilibrium is already known from antecedent, related models. What is new here is the disaggregation of the government into the treasury and the central bank and the specification of the behavior of the central bank.