September 2017 issue contents
Leaning Against the Wind When Credit Bites Back

by Karsten R. Gerdrup, Frank Hansen, Tord Krogh, and Junior Maih
Norges Bank

Abstract

This paper analyzes the cost-benefit trade-off of leaning against the wind (LAW) in monetary policy. Our starting point is a New Keynesian regime-switching model where the economy can be in a normal state or in a crisis state. The setup enables us to weigh benefits against costs for different systematic LAW policies. We find that the benefits of LAW in terms of a lower frequency of severe financial recessions exceed costs in terms of higher volatility in normal times when the severity of a crisis is endogenous (when "credit bites back"). Our qualitative results are robust to alternative specifications for the probability of a crisis. Our results hinge on the endogeneity of crisis severity. When the severity of a crisis is exogenous, we find that, if anything, it is optimal to lean with the wind.

JEL Codes: E12, E52, G01.

 
Full article (PDF, 34 pages, 490 kb)

Discussion by Carl E. Walsh