Monetary Policy and Endogenous Financial Crises

This paper asks whether a central bank should deviate from strict inflation targeting (SIT) to promote financial stability, studying the question in a textbook New Keynesian model augmented with capital accumulation and microfounded endogenous credit-market crises. The model embeds two financial frictions — limited contract enforcement and asymmetric information about firm productivity — that together generate fragile credit markets in which, when productive firms’ marginal return on capital falls below a threshold, the credit market collapses (a “financial crisis”). The calibrated model matches the empirical regularity that economies spend roughly 8% of time in financial crises. The central finding is threefold: (1) monetary policy affects crisis probability both in the short run (via output and markups) and in the medium run (via capital accumulation dynamics); (2) a Taylor-type rule that responds to output fluctuations — rather than SIT — reduces crisis incidence and raises welfare, with TR93 (φ_y = 0.125) generating a 0.016% permanent consumption equivalent gain over SIT; (3) prolonged unexpected monetary easing followed by abrupt tightening is itself a mechanism that can trigger financial crises. These findings imply a genuine price-versus-financial-stability tradeoff and challenge the “divine coincidence” view that SIT is sufficient in the presence of financial frictions.

Frédéric Boissay | Macro Paper Warehouse

Monetary Policy and Endogenous Financial Crises