Monetary Policy and Endogenous Financial Crises

• Authors: Cristina Manea, Frederic Boissay, Fabrice Collard and Jordi Galí.
• BSE Working Paper: 1308 | December 21
• Keywords: adverse selection , inflation targeting , financial crisis , low–for–long policy rate
• JEL codes: E1, E3, E6, G01

What are the channels through which monetary policy affects financial stability? Can (and should) central banks prevent financial crises by deviating from price stability? To what extent may monetary policy itself unintendedly brew financial vulnerabilities? We answer these questions using a New Keynesian model with capital accumulation and endogenous financial crises due to adverse selection and moral hazard in credit markets. Our findings are threefold. First, monetary policy affects the probability of a crisis both in the short–run (via aggregate demand) and in the medium–run (via capital accumulation). Second, the central bank can reduce the incidence of crises in the medium–run by tolerating higher inflation volatility in the short–run. Third, prolonged periods of loose monetary policy followed by a sharp tightening can lead to financial crises.