The occurrence of financial crises is not independent of how monetary policy is conducted. On the one hand, if monetary policy is looser, this may enhance financial instability. Yet, and depending on its timing, a very aggressive policy reaction may trigger a financial crisis.

In BSE Working Paper Nº 1308, “Monetary Policy and Endogenous Financial Crises” Frédéric Boissay, Fabrice Collard, Jordi Galí, and Cristina Manea study whether the central bank should deviate from its traditional price stability objective to promote financial soundness. They do so through the lens of a model in which financial crises arise in response to (possibly small) adverse shocks, but only when the economy is in a situation of financial fragility as a result of a gradual buildup of imbalances. In other words, the model allows for financial crises that are partly endogenous.

Firms are different, and that is relevant

The key aspect introduced in this model is that each period intermediate goods firms, ex-ante identical, suffer a shock that makes them either productive or unproductive. Depending on their type, each group of firms will have a target value of capital they want to hold. This target could be below or above their current capital stock, so firms fill these gaps by borrowing or lending in the credit market. Their decisions will depend in turn on the marginal return from their capital against the market’s rate. 

What can cause a financial crisis, and what role can the central bank play?

Three channels can generate a crisis in this model: a fall in aggregate output, a rise in retailers’ markups, or excess capital accumulation. The short-run scope for the effects of the central bank’s policy is related to the contemporary effects of changes in the interest rate on output and inflation. This is usually done in response to changes due to the output and markup effects.

In the medium run, monetary policy can affect households’ saving decisions and capital accumulation. Higher levels of capital in the economy will mean that smaller shocks can have a larger impact. Hence, a more aggressive policy in this sense could slow down capital accumulation during booms, thus attenuating the probability of a crisis. 

Anatomy of financial crises

As shown in the figure below, typical crises in the model are preceded by periods of small positive productivity shocks that increase the demand for capital goods by making capital more productive. This relative abundance puts downward pressure on the returns of capital by productive firms.

Eventually, the good times fade away, and output decreases. This leaves firms with an excess of capital, which increases lenders’ exposure to default risks. Then, a relatively small adverse shock can trigger a crisis, by making productive firms unable to borrow to meet their investment needs, thus preventing resources from being reallocated from unproductive to productive firms.

If capital accumulation were lower in the build-up phase, the same negative shock would not have had such an extreme impact. Here is where some scope for policy appears. 

Are there any gains in caring about things other than inflation?

The usual message in models that incorporate monetary policy targets is that a central bank that aims to follow strict inflation targeting policy is simultaneously stabilizing the output gap. This is called the ‘Divine Coincidence’. However, it may be beneficial to deviate from this in the presence of financial frictions as the ones present in this model.

The key trade-off is that putting more weight on output means a lower incidence of crises and, when they occur, spending less time in a crisis. However, this makes inflation more volatile. The authors find that if the monetary authority enacts a policy that departs from strict inflation targeting, the probability of crises diminishes because capital accumulation occurs slower in this case. By focusing more on curbing growth in boom episodes, the central bank makes investment in capital less attractive while also reducing the motive for households to do precautionary savings by making output less volatile. The downside is that these effects may take years to realize, so myopic central bankers will have little incentive to follow such a prescription.

Finally, the question is how much the monetary authority should lean against credit booms. As shown above, there is a threshold about which reacting more aggressively to output could undermine both price and financial stability, reducing overall welfare.

Overall, the paper’s analysis provides a rationale for deviating from a strict focus on inflation, especially during booms that may leave the economy with a capital overhang in the absence of an appropriate policy response.