Leaning against the wind when credit bites back

Karsten R. Gerdrup, Frank Hansen, Tord Krogh and Junior Maih
Additional contact information
Karsten R. Gerdrup: Norges Bank (Central Bank of Norway), http://www.norges-bank.no/
Frank Hansen: Norges Bank (Central Bank of Norway), http://www.norges-bank.no/
Tord Krogh: Norges Bank (Central Bank of Norway), http://www.norges-bank.no/

No 2016/9, Working Paper from Norges Bank

Abstract: This paper analyzes the cost-benefit trade-off of leaning against the wind (LAW) in monetary policy. Our starting point is a New Keynesian Markov-switching model where the economy can be in a normal state or in a crisis state. The set-up enables us to weigh benefits against costs for different systematic LAW policies. We find that the benefits of LAW in terms of a lower frequency of severe financial recessions exceed costs in terms of higher volatility in output and in inflation in normal times when i) agents underestimate crisis risk, and ii) the severity of crises is endogenous (i.e. when "credit bites back"). Furthermore, we find that using an asymmetric rule that only includes positive credit growth can reduce the frequency of severe financial recessions even further, but that this comes at the cost of higher volatility in normal times. Finally, we find that LAW policies can lead to relatively higher output volatility in normal times when agents perceive crisis risk correctly because they are already internalizing the risk of lower future consumption by reducing consumption today.

Keywords: Monetary policy; Financial stability; Leaning against the wind; Markovswitching; Endogenous crisis (search for similar items in EconPapers)
JEL-codes: E12 E52 G01 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2016-06-02
New Economics Papers: this item is included in nep-mac and nep-ore
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Citations: View citations in EconPapers (8)

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http://www.norges-bank.no/en/Published/Papers/Working-Papers/2016/92016/

Related works:
Journal Article: Leaning Against the Wind When Credit Bites Back (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:bno:worpap:2016_09

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