UK monetary policy in an estimated DSGE model with financial frictions

Abstract

This paper develops a dual-state monetary DSGE model that accommodates a refined financial accelerator to analyze UK monetary policy. Unconventional monetary policy (QE) is interpreted as expanding the central bank’s purchases of bonds using M0 to offset financial disruptions at the ZLB. Within a collateral-augmented costly state verification framework, M0 enters the financial accelerator as the cheapest collateral and reduces the cost of credit. The model is tested and estimated using indirect inference and found to fit the UK data for key variables over 1993–2016. We find that while financial shocks are significant, it is productivity shocks that had slowed down the recovery for 2009–2012. Alternative monetary regimes are evaluated and compared.