Monetary policy and endogenous financial crises

Abstract

What are the channels through which monetary policy affects financial stability? Can (and should) central banks prevent financial crises by tolerating higher price volatility? To what extent may monetary policy itself brew financial fragility? We study these questions through the lens of a textbook New Keynesian model augmented with capital accumulation and endogenous financial crises due to adverse selection in credit markets. Our main findings are threefold. First, monetary policy affects the probability of a crisis not only in the short–term (through its usual effects on aggregate demand) but also over the medium–term (through its effects on capital accumulation). Second, the central bank can significantly reduce the incidence of financial crises in the medium–term by tolerating higher price volatility in the short–term. Third, financial crises may occur after a long period of loose monetary policy, as the central bank abruptly reverses course and hikes its policy rate.