Monetary policy hysteresis and the financial cycle

BIS Working Papers  |  No 817  | 
03 October 2019
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 |  44 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.


This paper studies the interaction between monetary policy and macroeconomic stability in a model with two distinguishing features. First, financing - cash flows - underpins all economic activity, with banks generating deposits by granting loans. Money is non-neutral as the policy interest rate anchors the real economy. Second, bank lending is subject to an endogenous boom-bust cycle due to externalities in the loan market. Together, these features imply that monetary policy may have long-lasting impact on the real economy through its in fluence on the financial cycle. In this `finance-based' economy, there is no well-defined natural rate of interest to which the economy gravitates. The possibility of a `low interest rate trap' emerges: monetary policy that leans insufficiently against the build-up of financial imbalances increases 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.