Monetary policy hysteresis and the financial cycle

(October 2019, revised 17 May 2021)

Focus

What if monetary policy impart a long-run impact on output and inflation-adjusted interest rates -"non-neutrality"? What are the implications for the conduct of policy?

Contribution

We propose a stylised model with long-run monetary policy non-neutrality based on two key features. First, households have finite planning horizons and banks extend loans as well as create inside money, which is essential for economic activity. In this setting, there is no single 'natural rate of interest' to which the economy gravitates. Second, bank competition in the presence of externalities leads to endogenous boom-bust cycles. The model yields new insights about the role of monetary policy in macroeconomic stabilisation.

Findings

The economy's evolution over long horizons depends critically on the behaviour of the central bank. Short term-focused policy rules lead to more frequent boom-bust cycles as well as lower average real interest rates and output. In contrast to popular explanations, the secular decline in real interest rates need not reflect only saving-investment drivers - the monetary regime itself may play a contributing role.

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.

JEL codes: E52, E58, E43.

Keywords: monetary policy, financial cycle, money neutrality, hysteresis, natural rate of interest, intertemporal tradeoff