Research seminar: Leaning against persistent financial cycles with occasional crises

Thore Kockerols og Yasin Mimir

“Leaning against persistent financial cycles with occasional crises”

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Abstract: We investigate whether central banks should use leaning against the wind (LAW)-type monetary or macroprudential policy to address risks to financial stability under empirically plausible persistent financial cycles with occasional crises. Our main results do not support LAW by monetary policy because the costs of depressing the economy in normal times far outweigh the benefits of a less likely and less severe crisis. We first assess LAW as a one-off (nonsystematic) policy using an estimated large-scale dynamic stochastic general equilibrium (DSGE) model combined with a stylized regime-switching (RS) framework of normal and crisis times. We then evaluate policy-rule based (systematic) LAW using an endogenous RS version of our DSGE model with financial crises, effective lower bound (ELB) on interest rates, and an asymmetric LAW policy. The results under nonsystematic LAW are mainly driven by long-run output costs while under systematic LAW agents’ behavior changes such that results are driven by lower mean inflation. Furthermore, in both cases, LAW increases inflation volatility. Systematic LAW policies also result in more frequent ELB episodes due the to lower mean inflation rate they induce. The main result can be overturned if for systematic LAW the policymaker puts significantly more weight on output relative to inflation or if financial cycles are less persistent. Finally, we find that capital regulation is better suited to addressing risks to financial stability and the benefits increase with higher capital requirements in normal times.