Analysis of Monetary Policy Responses after Financial Market Crises in a Continuous Time New Keynesian Model

Abstract

To analyse the interdependence between monetary policy and financial markets in the context of the recent financial crisis, we use stochastic differential equations to develop a dynamic, stochastic general equilibrium New Keynesian model of two open economies. Our focus is on how stock and housing market bubbles are transmitted to and affect the domestic real economy and the consequent contagious effects on foreign markets. We simulate adjustment paths for the economies under two monetary policy rules: a standard open-economy Taylor rule and a modified Taylor rule that takes into account stabilisation of financial markets as a monetary policy objective. The results suggest a clear trade-off for monetary policymakers: under the modified rule, a severe economic recession can be avoided after a financial crisis but only at the price of a strong hike in inflation during the crisis and much more volatile inflation patterns during normal times, compared to under the standard Taylor rule. Using Bayesian estimation techniques, we calibrate the model to the cases of the United States and Canada and find that the resulting economic adjustment paths are similar to the ones we obtained from the extended Taylor rule theoretical model.

Keywords: New Keynesian Models, Financial Crisis, Dynamic Stochastic Full Equilibrium Continuous Time Model, Taylor Rule

JEL Classification: C02, C63, E44, E47, E52, F41