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Implications of the financial crisis for models in monetary policy

  • Stan du Plessis

    ()

    (Department of Economics, University of Stellenbosch)

Monetary authorities have been implicated in the financial crisis of 2007-2008. John Muellbauer, for example, has blamed what he thought was initially inadequate policy responses by central banks to the crisis on their models, which are, in his words, “overdue for the scrap heap”. This paper investigates the role of monetary policy models in the crisis and finds that (i) it is likely that monetary policy contributed to the financial crisis and (ii) that an inappropriately narrow suite of models made this mistake easier. The core models currently used at prominent central banks were not designed to discover emergent financial fragility. In that respect John Muellbauer is right. But the implications drawn here are less dramatic than his: while the representative agent approach to microfoundations now seems indefensible, other aspects of modern macroeconomics are not similarly suspect. The case made here is rather for expanding the suite of models used in the regular deliberations of monetary authorities, with new models that give explicit roles to the financial sector, to money and to the process of exchange. Recommending a suite of models for policy making entails no methodological innovation. That is what central banks do; though, of course, how they do it is open to improvement. The methodological innovation is the inclusion of a model that would be sensitive to financial fragility, a sensitivity that was absent in the run-up to the current financial crisis.

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File URL: http://www.ekon.sun.ac.za/wpapers/2010/wp182010/wp-18-2010.pdf
File Function: First version, 2010
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Paper provided by Stellenbosch University, Department of Economics in its series Working Papers with number 18/2010.

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Date of creation: 2010
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Handle: RePEc:sza:wpaper:wpapers117
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