Monetary policy and endogenous financial crises
(January 2022, revised August 2025)
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 deviating from price stability? To what extent may monetary policy itself unintendedly brew financial vulnerabilities? We answer these questions using a New Keynesian model with capital accumulation and endogenous financial crises due to adverse selection and moral hazard in credit markets. Our findings are threefold. First, monetary policy affects the probability of a crisis both in the short–run (via aggregate demand) and in the medium–run (via capital accumulation). Second, the central bank can reduce the incidence of crises in the medium–run by tolerating higher inflation volatility in the short–run. Third, prolonged periods of loose monetary policy followed by a sharp tightening can lead to financial crises.
JEL classification: E1, E3, E6, G01
Keywords: inflation targeting, low–for–long policy rate, adverse selection, financial crises
