Monetary Policy Hysteresis and the Financial Cycle

This paper studies the interaction between monetary policy and macroeconomic stability in a model with two distinguishing features. First, financing - cash flows - underpins all economic activity, with banks generating deposits by granting loans. Money is non-neutral as the policy interest rate anchors the real economy. Second, bank lending is subject to an endogenous boom-bust cycle due to externalities in the loan market. Together, these features imply that monetary policy may have long-lasting impact on the real economy through its in fluence on the financial cycle. In this 'finance-based' economy, there is no well-defined natural rate of interest to which the economy gravitates. The possibility of a 'low interest rate trap' emerges: monetary policy that leans insufficiently against the build-up of financial imbalances increases the vulnerability to financial busts over successive cycles. As a result, low rates can beget lower rates.