The Cost of Omitting the Credit Channel in DSGE Models: A Policy Mix Approach

Discussion papers from Policy Research Institute, Ministry of Finance Japan

Abstract: This paper examines whether the omission of the credit channel from policy models used by both monetary and fiscal policymakers would lead to a noticeably gbad h policy outcome through model simulation. First, we simulate a financial crisis in which the financial market friction grows and the risk premium becomes more volatile. Next, both monetary and fiscal policymakers readjust their policy to stabilize the economy using an approximating DSGE model that does not feature the credit channel. We show that while the model misspecification does not affect much how policymakers perceive the crisis, the newly adopted policy based on the approximating model would cause further destabilization of the economy. We also show that the destabilization of the economy could be prevented if the fiscal policymaker is equipped with the correctly-specified credit channel model and chooses its new policy while taking into account the decision-making of the monetary policymaker. Finally, under the scenario that the correctlyspecified model is unknown, we show that the destabilization of the economy could still be prevented if both policymakers can apply judgement to unreasonable parameter estimates during the crisis period. In sum, prediction of policy outcomes and cautiousness in interpreting estimation results can help in mitigating the credit channel misspecification.

Keywords: DSGE model; Lucas Critique; Bayesian estimation; Financial Accelerator model; monetary policy; fiscal policy; policy mix (search for similar items in EconPapers)
Pages: 39 pages
Date: 2020-03
New Economics Papers: this item is included in nep-cba, nep-cmp, nep-dge and nep-mac
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Citations: View citations in EconPapers (1)

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http://www.mof.go.jp/pri/research/discussion_paper/ron324.pdf First version, 2016 (application/pdf)

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