Monetary Policy and Endogenous Financial Crises
What this paper finds — and why it matters
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.
Summary of a published paper based on the NBER working paper full text, AI-assisted, pending human review. See the linked original for the authoritative claims and full conditions.
Layer 1: Overview
Boissay, Collard, Galí, and Manea build a New Keynesian model with capital accumulation and endogenous credit-market crises to study whether central banks should deviate from inflation targeting to promote financial stability. The model departs from the textbook three-equation NK framework in four ways: capital accumulation that allows persistent booms, firm heterogeneity in productivity that generates a credit market, financial frictions (limited enforcement and asymmetric information) that make the credit market fragile, and global (nonlinear) solution methods that can capture the boom-bust dynamics. A financial crisis — credit-market collapse — occurs when productive firms’ marginal return on capital falls below the minimum loan rate that unproductive firms require to willingly lend. The model is calibrated so that the economy spends 8% of time in crisis (consistent with cross-country evidence from Reinhart and Rogoff, Laeven and Valencia, and Baron et al.) and the additional parameter governing financial frictions (the proportion μ = 2.42% of unproductive firms) is chosen to match this target. Three main findings emerge: monetary policy operates through short-run aggregate demand channels and a medium-run capital accumulation channel; a Taylor-type rule that responds to output improves welfare over SIT, with TR93 raising permanent consumption by 0.016% relative to SIT; and discretionary loosening followed by abrupt tightening can itself generate crises.
Q1. How do financial crises arise in the model, and what is the triggering condition?
A financial crisis in the model is a credit-market breakdown in which the credit market collapses to autarky: unproductive firms stop lending because the loan rate they can credibly demand falls below the return on holding idle capital. The friction generating this fragility is a combination of limited contract enforcement (firms that borrow to purchase capital can abscond with sale proceeds) and asymmetric information about idiosyncratic productivity. Together, these frictions imply that productive firms cannot borrow beyond an incentive-compatible leverage cap, and that the minimum loan rate required to induce unproductive firms to lend is a positive threshold $\bar{r}^k = \mu/(1-\mu) - \delta$. A crisis occurs if and only if productive firms’ marginal return on capital $r_t^k$ falls below this threshold — which happens at the end of a protracted boom when the economy has accumulated excess capital, driving down marginal productivity. The average simulated crisis is triggered by a roughly three-standard-deviation negative TFP shock (around 1.5% below steady state) hitting an economy where the capital stock has been elevated by a long sequence of positive shocks. The same shock would not trigger a crisis at lower capital stocks — the capital overhang is a necessary precondition.
Q2. Through what channels does monetary policy affect financial stability, and how do short-run and medium-run channels differ?
The paper identifies three channels: a Y-channel (output), an M-channel (markups), and a K-channel (capital accumulation), with the K-channel operating only in the medium run through expectations about the policy rule. In the short run, a rate hike that compresses output and raises markups reduces the marginal return on capital, pushing the economy closer to a crisis — a destabilizing short-run effect. In the medium run, however, a commitment to lean against output booms (high φ_y) slows capital accumulation during expansions through two mechanisms: (i) it reduces investors’ expected returns from expansion, dampening incentives to accumulate capital; and (ii) it provides households with implicit insurance against aggregate shocks, reducing precautionary savings. Because capital accumulation is slow, these medium-run effects only materialize over multiple years and require that the central bank pre-commit to the rule. Expectations of the rule thus shape the boom dynamics before any crisis.
Q3. What does the welfare comparison across Taylor rules reveal about the price-versus-financial-stability tradeoff?
Responding to output raises welfare in the presence of financial frictions, even though it reduces welfare in the frictionless benchmark, generating a genuine price-versus-financial-stability tradeoff. Under strict inflation targeting, the welfare loss relative to the first best is 0.11% in consumption equivalent variation, entirely attributable to financial crises (since SIT eliminates price distortions). Responding more aggressively to output (higher φ_y) reduces crisis incidence from 9.85% of time (under SIT) to as low as 0.45% (under φ_y = 0.75), but raises inflation volatility. The welfare gain is non-monotone in φ_y: under the baseline φ_π = 1.5, welfare is highest around φ_y ≈ 0.5–0.6, and declines for higher φ_y as markup volatility (M-channel) more than offsets the financial stability gain. TR93 (φ_y = 0.125) already delivers 0.016% higher permanent consumption than SIT.
Q4. What is the role of monetary policy discretion in generating financial crises?
The model shows that sustained discretionary loosening followed by abrupt tightening can itself trigger a crisis, formalizing the “rates too low for too long” narrative of the 2007-08 Global Financial Crisis. Using only monetary policy shocks (either AR(1) with ρ = 0.5, σ = 0.25% or i.i.d.) as the source of aggregate uncertainty, the average simulated crisis follows a long period of unexpectedly accommodative policy that feeds an investment boom, with the crisis triggered by three consecutive unexpected rate hikes (persistent shock case) or a single 60-basis-point jolt (i.i.d. case) at the end of the boom. This is consistent with empirical evidence (Schularick, Ter Steege, and Ward 2021) that unanticipated rate hikes at the end of a boom are more likely to trigger crises than prevent them.
Q5. How much additional welfare gain is available from a “backstop” commitment that forestalls crises entirely?
A nonlinear backstop rule — under which the central bank deviates from its normal rule just enough to prevent a crisis whenever one would otherwise occur — nearly eliminates the welfare cost of financial crises, requiring only modest policy deviations. Under SIT, the backstop improves welfare by 0.11% in consumption equivalent variation — the full cost of crises — leaving a residual welfare loss of only 0.0013% relative to the first best. The backstop requires rate cuts of on average 20 basis points below TR93, or tolerance of 0.6 percentage points of extra inflation above the SIT target, in the periods when a crisis would otherwise emerge. The tradeoff is that backstopping increases the frequency with which the central bank must intervene, since knowing that the bank will intervene can increase the financial sector’s risk-taking (fragility).
Q6. How does the paper’s approach to microfounding crises compare to reduced-form alternatives?
Unlike Woodford (2012) and Gourio, Kashyap, and Sim (2018), who use reduced-form functions linking credit or leverage gaps to crisis probability, this paper derives crisis probability and severity endogenously from first principles, with implications for the policy prescriptions. Because crises and their depth are both endogenous to policy, the model can determine not only how policy affects the probability of a crisis but also how it affects the size of the output loss conditional on a crisis. This distinction matters: the model shows that not all credit booms are equally dangerous — a boom accompanied by genuine productivity gains carries lower crisis risk than an equivalent capital accumulation driven by precautionary saving externalities. The endogenous crisis mechanism also implies that some forms of leaning that superficially appear to reduce crisis probability may actually increase it by raising markup volatility, an effect absent from reduced-form models.
Key Concepts
divine coincidence : the standard New Keynesian result that strict inflation targeting (SIT) simultaneously eliminates output gap fluctuations and is welfare-optimal in the absence of financial frictions; the paper shows this coincidence breaks down when the credit market is fragile, because SIT does not internalize the externalities driving capital overhang and crisis risk.
financial crisis (in the model) : the autarkic equilibrium of the credit market, in which productive firms’ marginal return on capital falls below the minimum loan rate required for unproductive firms to willingly lend; characterized by credit-market collapse, capital misallocation (unproductive firms retain idle capital), severe output loss, and inflationary pressure.
K-channel of monetary policy on financial stability : the medium-run mechanism by which a commitment to respond strongly to output fluctuations dampens capital accumulation during booms, reducing the likelihood of the excess capital overhang that triggers crises; operates through expectations and requires multi-year lead times, distinguishing it from the short-run output (Y) and markup (M) channels.
savings glut externality : the tendency of households to over-accumulate capital relative to the socially efficient level in anticipation of a crisis, because individual households do not internalize the aggregate effect of their precautionary saving on the economy’s distance from the credit-market collapse threshold; identified by Boissay, Collard, and Smets (2016) and present in this model as a driver of endogenous boom-bust dynamics.
backstop rule : a nonlinear monetary policy rule in which the central bank follows a standard Taylor or SIT rule in normal times but commits to deviating just enough from that rule to forestall a financial crisis whenever one would otherwise emerge; shown to nearly eliminate the welfare cost of crises at the cost of modest and infrequent policy deviations, with the side effect of increasing the frequency of needed interventions.