Working Paper: CEPR ID: DP16825
Authors: Frederic Boissay; Fabrice Collard; Jordi Gal; Cristina Manea
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.
Keywords: financial crises; monetary policy
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy (E52) | Probability of financial crisis (G01) |
| Policies which dampen output fluctuations (E63) | Likelihood of crises (H12) |
| Central bank deviating from strict inflation targeting (E52) | Crisis probabilities (G01) |
| Taylor-type rule incorporating output responses (C51) | Welfare outcomes (I38) |
| Prolonged period of unexpectedly loose monetary policy (E52) | Financial crises (G01) |
| Sudden policy reversals (E65) | Crises (H12) |