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Financial crises, unconventional monetary policy exit strategies, and agents' expectations

  • Andrew T. Foerster

This paper considers a model with financial frictions and studies the role of expectations and unconventional monetary policy response to financial crises. During a financial crisis, the financial sector has reduced ability to provide credit to productive firms, and the central bank may help lessen the magnitude of the downturn by using unconventional monetary policy to inject liquidity into credit markets. The model allows parameters to change according to a Markov process, which gives agents in the economy expectation about the probability of the central bank intervening in response to a crises, as well as expectations about the central bank's exit strategy post-crises. Using this Markov regime switching specification, the paper addresses three issues. First, it considers the effects of different exit strategies, and shows that, after a crisis, if the central bank sells off its accumulated assets too quickly, the economy can experience a double-dip recession. Second, it analyzes the effects of expectations of intervention policy on pre-crises behavior. In particular, if the central bank increases the probability of intervening during crises, this increase leads to a loss of output in pre-crisis times. Finally, the paper considers the welfare implications of guaranteeing intervention during crises, and shows that providing a guarantee can raise or lower welfare depending upon the exit strategy used, and that committing before a crisis can be welfare decreasing but then welfare increasing once a crisis occurs.

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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 11-04.

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Date of creation: 2011
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Handle: RePEc:fip:fedkrw:rwp11-04
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