Financial Frictions and the Volatility of Monetary Policy in a DSGE model

Abstract

The paper investigates the impacts of the volatility of monetary policy on the economy in a DSGE model with financial frictions a la Bernanke, Gertler, and Gilchrist (1999). The model is estimated by the particle filter maximum likelihood estimator for the U.S. economy. Our results first show that a positive monetary volatility shock causes a contraction in economic activity: output, consumption, investment, hours, and real wages fall. Second, we argue that financial frictions amplify the effects of the shock via the financial accelerator mechanism. Third, we document that the size of the effects of the shock is relatively small mostly because of the counteracting response of monetary policy to the shock. Therefore, the impacts would be substantial if monetary policy was restrained to respond to changes in current conditions in the economy.

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