Credit Cycles and Monetary Policy in a Model with Regime Switches

54 Pages Posted: 30 Nov 2018

See all articles by Timm Faulwasser

Timm Faulwasser

Karlsruhe Institute of Technology

Marco Gross

International Monetary Fund (IMF); European Central Bank (ECB)

Willi Semmler

The New School - Department of Economics; Universitaet Bielefeld; IIASA

Date Written: November 1, 2018

Abstract

The control of credit cycles has become a major issue for monetary policy authorities. We include in an inflation targeting model of the type developed by Svensson (1997) a nonlinear Phillips curve – allowing for a state-dependent relation of the inflation rate and the output gap – and add nonlinear dynamics for credit flows and loan interest rate spreads. As to the latter, we follow up the Minsky hypothesis that “booms sow the seeds of the next crisis”, in the sense that in credit expansions risk premia and credit spreads are low and in contractions they are high. We solve the finite horizon monetary policy model for assessing the dynamic effects of price-oriented as well as credit volume-oriented monetary policy variants. We estimate our nonlinear simultaneous equation system based on data for the euro area, to thereby inform the model parameters and explore the (de-)stabilizing effects of price (credit cost) and non-price (credit volume) drivers of the output gap, inflation and credit flows. Yet, the endogenous over- and undershooting of credit flows can significantly be impacted by quantitative easing (QE) policies. On the basis of a proposed small-scale nonlinear quadratic (NLQ) model with two regime switches – similar to more complex large-scale models – we can assess the effects of conventional and unconventional monetary policy for various economic scenarios with endogenous credit flows, risk build up and credit spread movements.

Keywords: Nonlinearities, Inflation Targeting, Credit Cycles, Credit Risk and Credit Spreads, Phillips Curve, Conventional and Unconventional Monetary Policy

JEL Classification: E30, E43, E44, E52

Suggested Citation

Faulwasser, Timm and Gross, Marco and Semmler, Willi, Credit Cycles and Monetary Policy in a Model with Regime Switches (November 1, 2018). Available at SSRN: https://ssrn.com/abstract=3288763 or http://dx.doi.org/10.2139/ssrn.3288763

Timm Faulwasser

Karlsruhe Institute of Technology ( email )

Kaiserstraße 12
Karlsruhe, Baden Württemberg 76131
Germany

Marco Gross

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Willi Semmler (Contact Author)

The New School - Department of Economics ( email )

65 Fifth Avenue
New York, NY 10003
United States

HOME PAGE: http://www.newschool.edu/nssr/faculty/?id=4e54-6b79-4e41-3d3d

Universitaet Bielefeld ( email )

Universitätsstraße 25
Bielefeld, NRW
Germany

IIASA ( email )

Schlossplatz 1
Laxenburg/Austria, A-2361
Austria

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