Monetary policy hysteresis and the financial cycle

Phurichai Rungcharoenkitkul, Claudio Borio and Piti Disyatat

No 817, BIS Working Papers from Bank for International Settlements

Abstract: A long tradition of macroeconomic analysis accords monetary policy only a transient role in driving real outcomes. At the same time, a large body of evidence highlights the long-lasting impact of boom-bust cycles. We present a model where monetary policy, through its impact on and reaction to the financial cycle, influences long-term economic trajectories. The core setup is an overlapping generations model featuring bank financing – the creation of bank loans and inside money – which is critical for production and consumption. Monetary policy attains the first-best allocation by sustaining an efficient flow of financing. We then introduce coordination-failure frictions among lenders, which give rise to an endogenous boom-bust cycle in bank financing and an intertemporal policy tradeoff. A forward-looking policymaker optimally leans against excessive risk-taking during the boom, trading off short-term activity with longer-term stability. An inordinate focus on short-term outcomes can lead to `monetary policy hysteresis', where low interest rates increase the vulnerability to financial busts over successive cycles. As a result, low rates can beget lower rates.

Keywords: monetary policy; financial cycle; money neutrality; hysteresis; natural rate of interest; intertemporal tradeoff (search for similar items in EconPapers)
JEL-codes: E43 E52 E58 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2019-10
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (27)

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