Monetary Policy and Credit Supply Shocks

The depth and duration of the 2007–09 recession serves as a powerful reminder of the real consequences of financial shocks. Although channels through which disruptions in financial markets can affect economic activity are relatively well understood from a theoretical perspective, assessing their quantitative implications for the real economy remains a considerable challenge. This paper examines the extent to which the workhorse New Keynesian model—augmented with the standard financial accelerator mechanism—is capable of producing the dynamics of the U.S. economy during the recent financial crisis. To do so, we employ the methodology of Gilchrist and Zakrajšek (2011) to construct a measure of shocks to the financial sector, which is then used to simulate the model over the crisis period. The results indicate that a reasonably calibrated version of the model can closely match the observed decline in economic activity and can account for the sharp widening of nonfinancial credit spreads, a decline in nominal short-term interest rates, and for the persistent disinflation experienced in the wake of financial disruptions. Given its empirical relevance, we then use this framework to analyze the potential benefits of a monetary policy rule that allows the short-term nominal rate to respond to changes in financial conditions as measured by movements in credit spreads. The results indicate that such a spread-augmented policy rule can effectively dampen the negative consequences of financial disruptions on real economic activity, while engendering only a modest increase in inflation.