Tight Money-Tight Credit: Coordination Failure in the Conduct of Monetary and Financial Policies

Quantitative analysis of a New Keynesian model with the Bernanke-Gertler accelerator and
risk shocks shows that violations of Tinbergen’s Rule and strategic interaction between policy-making authorities undermine significantly the effectiveness of monetary and financial policies.
Separate monetary and financial policy rules, with the latter subsidizing lenders to encourage
lending when credit spreads rise, produce higher welfare and smoother business cycles
than a monetary rule augmented with credit spreads. The latter yields a tight money-tight credit
regime in which the interest rate responds too much to inflation and not enough to adverse
credit conditions. Reaction curves for the choice of policy-rule elasticity that minimizes each
authority’s loss function given the other authority’s elasticity are nonlinear, reflecting shifts
from strategic substitutes to complements in setting policy-rule parameters. The Nash equilibrium
is significantly inferior to the Cooperative equilibrium, both are inferior to a first-best
outcome that maximizes welfare, and both produce tight money-tight credit regimes.