Conventional and unconventional monetary policy in a DSGE model with an interbank market friction

Abstract

This thesis examines both conventional and unconventional monetary policies in a DSGE model with an interbank market friction. The recent crisis during 2007-2009 affected economies worldwide and forced central banks to implement not just conventional monetary policies, but also direct interventions in financial markets. We investigate a DSGE model with financial frictions, to test conventional and unconventional monetary policies. The thesis starts by using the Gertler and Kiyotaki (2010)’s modelling framework, to examine eight different shocks under imperfect interbank market conditions. Unlike Gertler and Kiyotaki (2010) who consider the two extreme cases for the banking system, I firstly extend the analysis to a case in between the two extreme cases that they examined. The shocks considered include supply and demand shocks and also two shocks from the financial system itself (an interbank market shock and a shock to the deposit market). It is found that a negative shock to the interbank market has only a moderate impact to the banking system. However, a shock to the deposit market has a much stronger impact. Even though the impacts of these shocks are not large it is shown that thefinancial frictions magnify the effects of other shocks. The model is extended to include price stickiness. A modified Taylor rule is analysed to test how conventional monetary policy should respond to the shocks in the presence of financial frictions. Specifically the credit spread is added as a third term in the monetary policy rule. The stabilising properties of the policy rule are analysed and a welfare analysis is conducted. The model is further developed to include unconventional monetary policy in the form of direct lending to private sector firms from the central bank. A policy rule for unconventional policy is tested and its stabilising and welfare properties are analysed.