The business cycle and monetary policy: what changed after the GFC?

Abstract

To examine changes in the nature of the business cycle and its interaction with monetary policy we estimate a small open economy New Keynesian model using two time periods, one prior to the Global Financial Crisis (GFC) of 2007–2009 and one post the financial crisis. The model has the standard features of sticky prices and monopolistic competition. To fit the data the model also allows for households with a degree of habit persistence and a proportion of firms whose pricing decisions are simply to index to past inflation. Our results indicate the main difference pre- and post-GFC is that the economy has become less interest rate sensitive. Therefore, to stabilize the output and inflation, monetary policy actions need to be stronger than they were prior to the GFC. Moreover, the reduction in neutral interest rates post-GFC has resulted in additional transitional dynamics that have lowered inflation and output.