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


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