Long-run scarring effects of meltdowns in a small-scale nonlinear quadratic model
26 Pages Posted: 16 Aug 2019 Last revised: 22 Feb 2022
Date Written: February 21, 2022
Abstract
We build a small-scale nonlinear quadratic (NLQ) model in which credit feedback and regime switches in the output gap affect the adjustment path of the economy towards a steady state. The central bank solves a finite-horizon decision problem where the policy rate also can be zero or negative. We estimate this model by nonlinear seemingly unrelated regression method (NLSUR) and using the parameters to explore policy scenarios. The latter projects long-run dynamics after a large demand contraction leading to scarring effects in the economy. We point out three main results. First, while scars are dominant when the central bank follows a standard Taylor rule, unconventional monetary policy (UMP) mitigates the output decline in both the short and the long run. Second, a zero natural rate of interest alone curtails the central bank's ability to adjust the economy. Third, financial constraints leave the deepest scars even if UMP is active.
Keywords: credit cycles, credit spread, inflation targeting, nonlinear Phillips curve, unconventional monetary policy
JEL Classification: E42, E52, E58
Suggested Citation: Suggested Citation