Monetary policy, financial uncertainty, and secular stagnation

A monetary policy framework describing how to cope with a financial crisis might alleviate a recession; however, it might also result in subsequent secular stagnation. Based on an empirical New Keynesian model with financial uncertainty, this study investigates how monetary policy can avoid sluggish economic recovery in response to financial shocks. The results show that a protracted sluggish response of an output gap to a financial shock is triggered by inflation targeting, without considering interest rate variations. In such a policy, the uncertainty causes additional sluggish behavior after a sharp reduction in the output gap. In contrast, in a speed limit policy, the output gap recovers rapidly, regardless of the central bank’s approach to interest rate variations, and the uncertainty mitigates reductions in the output gap. Finally, the results are robust under several alternative settings.