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 and aggregate output.
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”) 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 fluctuations in output. Third, financial crises may occur after a long period of unexpectedly loose monetary policy as the central bank abruptly reverses course.
Abstract
We study whether a central bank should deviate 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 microfounded endogenous financial crises. We compare several interest rate rules, under which the central bank responds more or less forcefully to inflation and aggregate output. Our main findings are threefold. 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, a central bank can both reduce the probability of a crisis and increase welfare by departing from strict inflation targeting and responding systematically to fluctuations in output. Third, 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.
Frederic Boissay, Fabrice Collard, Jordi Galí, Cristina Manea
