Monetary Policy and Endogenous Financial Crises

Should a central bank deviate from price stability to promote financial stability? We study this question through the lens of a textbook New Keynesian model augmented with capital accumulation and search–for–yield behaviors that give rise to endogenous financial crises. Our main findings are fourfold. First, monetary policy affects the probability of a crisis both in the short run (through aggregate demand) and in the medium run (through savings and capital accumulation). Second, the central bank can lower the probability of a crisis and increase welfare compared to strict inflation targeting by responding to output and an index of financial fragility (the “yield gap”) in addition to inflation. Third, “backstop” policy rules that prevent credit market collapses can further increase welfare. Fourth, financial crises may occur after a long period of unexpectedly loose monetary policy as the central bank abruptly reverses course.