Title: Leaning against persistent financial cycles with occasional crises
Download PDF: Working Paper 56
This paper quantitatively investigates conditions under which a leaning against the wind (LAW)-type monetary policy is advisable to address risks to financial stability.
Authors: Thore Kockerols (ECB), Erling Motzfeldt Kravik (Norwegian Ministry of Finance), Yasin Mimir (ESM)
We study conditions under which a leaning against the wind (LAW)-type monetary policy is advisable to address risks to financial stability. We do so within a regime-switching dynamic stochastic general equilibrium (DSGE) model with endogenous crises and persistent financial cycles based on partly backward-looking house price beliefs. Under empirically plausible financial cycles, LAW increases inflation volatility because it amplifies the effects of supply shocks on inflation. It also leads to a lower average inflation, resulting in more frequent episodes of a binding lower bound on interest rates. LAW is advisable only if (i) the central bank puts more weight on output stability or (ii) financial cycles are less persistent than observed.
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Keywords: leaning against the wind, monetary policy, financial cycle, regime-switching DSGE
JEL codes: E52, E58, G01