Monetary policy hysteresis and the financial cycle

(October 2019, revised 29 August 2020)

BIS Working Papers  |  No 817  | 
03 October 2019
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 |  54 pages


What if monetary policy impart a long-run impact on output and inflation-adjusted interest rates -"non-neutrality"? What are the implications for the conduct of policy?


We propose a stylised model with long-run monetary policy non-neutrality based on two key features. First, households have finite planning horizons and banks extend loans as well as create inside money, which is essential for economic activity. In this setting, there is no single 'natural rate of interest' to which the economy gravitates. Second, bank competition in the presence of externalities leads to endogenous boom-bust cycles. The model yields new insights about the role of monetary policy in macroeconomic stabilisation.


The economy's evolution over long horizons depends critically on the behaviour of the central bank. Short term-focused policy rules lead to more frequent boom-bust cycles as well as lower average real interest rates and output. In contrast to popular explanations, the secular decline in real interest rates need not reflect only saving-investment drivers - the monetary regime itself may play a contributing role.


A long tradition of macroeconomic analysis accords monetary policy only a transient role in driving real outcomes. At the same time, a large body of evidence highlights the persistent impact of financial cycles, particularly those that end in crises. We present a model where monetary policy, through its impact on the financial cycle, influences long-term economic trajectories. The model has two distinguishing features. First, financing underpins economic activity, with bank loans and the associated creation of inside money acting as the critical impetus for production and consumption. Under monetary exchange, the goods market always clears and there is no natural rate of interest. Instead, the central bank anchors the real interest rate, even in the long run. Second, externalities in the loan market generate an endogenous boom-bust cycle in bank lending. A forward-looking policymaker optimally leans against the build-up of financial imbalances during the boom, trading off short-term activity with longer-term stability. An inordinate focus on short-term outcomes can lead to 'monetary policy hysteresis', where low interest rates increase the vulnerability to financial busts over successive cycles. As a result, low rates can beget lower rates.

JEL codes: E52, E58, E43.

Keywords: monetary policy, financial cycle, money neutrality, hysteresis, natural rate of interest, intertemporal tradeoff