Credit Cycles and Monetary Policy in a Model with Regime Switches

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.