Monetary policy hysteresis and the financial cycle

A long tradition of macroeconomic analysis accords monetary policy only a transient role in driving real outcomes. At the same time, a large body of evidence highlights the long-lasting impact of boom-bust cycles. We present a model where monetary policy, through its impact on and reaction to the financial cycle, influences long-term economic trajectories. The core setup is an overlapping generations model featuring bank financing – the creation of bank loans and inside money – which is critical for production and consumption. Monetary policy attains the first-best allocation by sustaining an efficient flow of financing. We then introduce coordination-failure frictions among lenders, which give rise to an endogenous boom-bust cycle in bank financing and an intertemporal policy tradeoff. A forward-looking policymaker optimally leans against excessive risk-taking during the boom, trading off short-term activity with longer-term stability. An inordinate focus on short-term outcomes can lead to `monetary policy hysteresis', where low interest rates increase the vulnerability to financial busts over successive cycles. As a result, low rates can beget lower rates.