Financial Frictions and Stabilization Policies

Abstract

After the financial crisis of 2007, in most economies carrying out either fiscal consolidations or counter-cyclical fiscal policies, public and private debt have moved in opposite directions, as opposed to pre-2007 evidence. Private deleverage and public debt build-up may affect the recovery path of countries after a recession. In a new Keynesian model with financial frictions, we show that when the economy is hit by a credit risk shock, the negative correlation that arises between public and private debt amplifies the response of GDP. In our setup, the traditional monetary-fiscal policy mix is not enough to offset this public-private debt mechanism and therefore bring back economic stability. When macroprudential policy is part of the policy mix, the public-private debt channel can be broken. Interestingly, depending on the macroprudential instrument, a trade-off may arise between private debt and output stabilization.