Output Gap in Presence of Financial Frictions and Monetary Policy Trade-offs

Abstract

The recent global financial crisis illustrates that financial frictions are a significant source of volatility in the economy. This paper investigates monetary policy stabilization in an environment where financial frictions are a relevant source of macroeconomic fluctuation. We derive a measure of output gap that accounts for frictions in financial market. Furthermore we illustrate that, in the presence of financial frictions, a benevolent central bank faces a substantial trade-off between nominal and real stabilization; optimal monetary policy significantly reduces fluctuations in price and wage inflations but fails to alleviate the output gap volatility. This suggests a role for macroprudential policies.

Debt-deflation, financial market stress and regime change – Evidence from Europe using MRVAR

“…If we admit debt overhang and disinflation and deflation, and endogenously generated credit constraints, risk premia and credit spreads, we can observe destabilizing effects in the theoretical and credit spread, see Furlanetto et al (2014)). model, with persistent contractions and no debt sustainability.…”

Steady as She Goes-Estimating Potential Output During Financial 'Booms and Busts'

“…A DSGE approach can shed light on the economic forces illuminated by the MVF. The modeling approach combines two strands of the recent literature-a new generation of DSGE models, which incorporate financial frictions into the standard New Keynesian model with price and wage rigidities (e.g., Christiano, Motto, and Rostagno, 2013;Furlanetto, Gelain, and Taheri Sanjani, 2014), and two-country models with housing that improve our understanding of monetary and macroprudential policy tradeoffs in the euro area (Aspachs-Bracons and Rabanal, 2011;Quint and Rabanal, 2014). 18…”

“…This could mean, for instance, more assertive tightening during a period of credit-fueled overheating than in the absence of strong credit growth. Moreover, the presence of financial frictions, if they cannot be addressed by other means, introduce new tradeoffs for monetary policymakers (Furlanetto, Gelain, and Taheri Sanjani, 2014).…”

“…The latest generation of estimated DSGE models also incorporates financial frictions, including the role of credit and asset markets, banks, and the housing market (see, for instance, Christiano, Motto, and Rostagno, 2014). Furlanetto, Gelain and Taheri Sanjani (2014) explicitly measure the effect of financial frictions on estimated potential output. 8 Among other things, this new model class can, in principle, provide additional insights on how the concepts of potential and sustainable output are linked-for example by helping to distinguish between sustainable changes in output linked to a reduction in financial frictions from creditfueled growth.…”

“…A two-region DSGE model with financial frictions and housing backs the findings of the MVF for the euro area. 10 Similarly to Furlanetto, Gelain and Taheri Sanjani (2014), the model has an explicit role for leverage and credit risk. In this setting, it is possible to distinguish sustainable changes in potential output linked to a reduction in financial frictions from credit-fueled growth triggered by temporary surges in demand.…”