Monetary policy and endogenous financial crises

(January 2022, revised July 2024)

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

What are the channels through which monetary policy affects financial stability? Can (and should) central banks prevent financial crises by tolerating higher price volatility? To what extent may monetary policy itself brew financial fragility? We study these questions through the lens of a textbook New Keynesian model augmented with capital accumulation and endogenous financial crises due to adverse selection in credit markets. Our main findings are threefold. First, monetary policy affects the probability of a crisis not only in the short–term (through its usual effects on aggregate demand) but also over the medium–term (through its effects on capital accumulation). Second, the central bank can significantly reduce the incidence of financial crises in the medium–term by tolerating higher price volatility in the short–term. Third, financial crises may occur after a long period of loose monetary policy, as the central bank abruptly reverses course and hikes its policy rate.

JEL classification: E1, E3, E6, G01

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