DP16825 Monetary Policy and Endogenous Financial Crises

Author(s): Frederic Boissay, Fabrice Collard, Jordi Galí, Cristina Manea
Publication Date: December 2021
Date Revised: January 2022
Keyword(s): financial crises, monetary policy
JEL(s):
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16825

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.