Credit Shocks, Monetary Flows, and Quantitative Tightening
73 Pages Posted: 9 Jun 2017 Last revised: 13 Aug 2019
Date Written: January 22, 2019
The U.S. Federal Reserve has been steadily shrinking its balance sheet as part of its effort to normalize policy following the financial crisis. Other central banks have announced similar intentions, potentially resulting in the withdrawal of an unprecedented amount of liquidity from the global economy. We propose a modeling framework for analyzing the effects of such policies in which changes in monetary quantities, in particular, the supply and demand for credit, influence economic activity. Persistent dynamics are introduced by explicit modeling of long-term loan obligations held by both the central bank and the financial sector. This introduces a type of path dependence, or "system memory": the current state of the economy, and hence its future trajectory, depends on the sequence of past loans. Shocks or sudden policy shifts can therefore have long-term effects, potentially spanning many years, even in a frictionless setting with complete information available to all agents. An additional feature of the model is that the production of capital is financed, and requires labor as an input. Labor is therefore allocated across two economic sectors: one producing consumer goods, and the other producing capital inputs. We find that (1) The dynamics of a credit expansion and contraction are asymmetric with contractions being more volatile than expansions. Furthermore, expansions and contractions with downward wage friction cause co-movement in unemployment across economic sectors. (2) Shrinking the central bank's balance sheet will not cause a contraction, provided that the financial sector expands credit to compensate for the outgoing monetary flow. (3) Rigidities in the loan portfolio across time cause the real interest rate to vary with inflation -- even in steady state.
Keywords: long-term loans, capital investment, path dependence, credit cycle, credit contraction
JEL Classification: E10
Suggested Citation: Suggested Citation