Expectation Management and Financial Stability – Dynamic Stochastic General Equilibrium Based on News Shock

Abstract

After the financial crisis in 2008, finance has been considered a significant cause of the fluctuations in the business cycle. This study introduces the expected monetary policy into a dynamic stochastic general equilibrium (DSGE) model that includes a mechanism of finance amplifying the fluctuations in the business cycle. It compares and analyzes the effects of expected and unexpected monetary policy on financial variables that comprise real estate price and credit. The results show that regarding the shock of reinforcing monetary policy, the expected and unexpected monetary policies have resulted in the reduction of real estate price and credit. However, the unexpected monetary policy has resulted in a greater effect on real estate price and credit. The rapid decline in real estate price and credit may cause severe fluctuations in the business cycle owing to the role of financial accelerators. Therefore, the expected monetary policy can better stabilize finance. Moreover, the expected duration of monetary policy by the entities in the Chinese economic market is found to be one-quarter. Central bank should try to avoid releasing sudden and unexpected monetary policy news to the public, as this will result in severe fluctuations in credit and real estate price, which can further result in severe fluctuations in the business cycle. Central bank should also adopt the monetary policy of expectation management to stabilize finance to further mitigate the magnifying effect of financial factors on fluctuations in the business cycle and prevent systemic financial risks.