Monetary policy and endogenous financial crises

(January 2022, revised April 2023)

BIS Working Papers  |  No 991  | 
18 January 2022

Summary

Focus

We ask whether a central bank should turn aside from its objective of price stability to promote financial stability. We tackle this question within a textbook New Keynesian model augmented with capital accumulation and crises that originate within the financial system. We compare several interest rate rules, under which the central bank responds more or less forcefully to inflation, aggregate output and an index of financial fragility (the "yield gap").

Contribution

Our model departs from the textbook model in a few but important ways. Excess accumulation of capital may induce the economy to deviate persistently from its steady state, resulting in financial imbalances. Firms are subject to productivity shocks that lead to capital being reallocated between productive and unproductive firms via a credit market. Financial frictions make this credit market fragile and prone to sudden collapses ("financial crises") especially towards the end of investment booms.

Findings

Our main findings are, first, that monetary policy can make a financial crisis more or less likely both in the short run (through aggregate demand) and in the medium run (through savings and capital accumulation). Second, a central bank can make a crisis less likely, while increasing social welfare, by departing from strict inflation targeting and responding systematically to output and the yield gap. Third, "backstop" rules that prevent credit market collapses can further increase welfare. Fourth, financial crises may occur after a long period of unexpectedly loose monetary policy as the central bank abruptly reverses course.


Abstract

Should a central bank deviate from price stability to promote financial stability? We study this question through the lens of a textbook New Keynesian model augmented with capital accumulation and search–for–yield behaviors that give rise to endogenous financial crises. Our main findings are fourfold. First, monetary policy affects the probability of a crisis both in the short run (through aggregate demand) and in the medium run (through savings and capital accumulation). Second, the central bank can lower the probability of a crisis and increase welfare compared to strict inflation targeting by responding to output and an index of financial fragility (the "yield gap") in addition to inflation. Third, "backstop" policy rules that prevent credit market collapses can further increase welfare. Fourth, financial crises may occur after a long period of unexpectedly loose monetary policy as the central bank abruptly reverses course.

JEL classification: E1, E3, E6, G01

Keywords: inflation targeting, low–rate–for–long, search for yield, financial instability, backstops